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VI Trading

From: EU Securities and Financial Markets Regulation (3rd Edition)

Niamh Moloney

From: Oxford Legal Research Library (http://olrl.ouplaw.com). (c) Oxford University Press, 2023. All Rights Reserved. Subscriber: null; date: 06 June 2023

Sovereign debt markets — European Securities and Markets Authority (ESMA) — UK Financial Services Authority (FSA) — Securities and Exchange Commission (SEC) — Financial Stability Board (FSB) — Derivatives — International Organisation of Securities Commissions (IOSCO)

(p. 511) VI  Trading

VI.1  Introduction

VI.1.1  Regulating Trading: Financial Stability and Anti-speculation

This Chapter is concerned with trading (order execution) in financial instruments. Regulation of the trading process has long been associated with the support of market efficiency and efficient resource allocation, and with the related protection of liquidity and the facilitation of risk management.1 Trading regulation has also long been associated, particularly in the brokerage context, with investor protection, given the significant agency risks, including with respect to competence failures and conflicts of interest, which can arise. EU trading regulation, prior to the crisis-era reforms, was primarily a function of the 2004 MiFID I2 regime for investment services and activities—broking and dealing investment services/activities were subject to authorization (and remain so under the 2014 MiFID II/MiFIR regime).3 The trading-specific rules were primarily conduct-orientated, and included order handling and best execution requirements. Trading between dealers or between dealers and professional counterparties, however, was generally exempted from conduct regulation. MiFID I also subjected trading to the prudential requirements which applied to investment services generally, including organizational and trading book capital requirements.

In addition to market efficiency and investor protection risks, trading—and particularly proprietary dealing—can generate systemic risks, particularly where solvency risks generated by severe market losses are passed down a chain of counterparties and disrupt liquidity and stability.4 But while the EU capital requirements regime addressed trading book risk,5 the EU regime did not otherwise regulate the stability risks generated by trading in any significant way. The crisis-era reform agenda, however, has re-characterized EU trading (p. 512) regulation. In addition to addressing market efficiency and investor protection, trading regulation is now closely concerned with the support of financial stability.

Much of the financial stability agenda has focused on derivatives trading and so reflects the related G20 agenda (section 4). The systemic instability which can flow from trading positions in derivatives and from related poor risk management was laid bare by the difficulties which the over-the-counter (OTC) derivatives segment, and in particular credit derivatives, experienced over the crisis. Extensive reforms have followed. As the crisis receded, the massive losses sustained by JP Morgan Chase in 2012 from the controversial ‘London Whale’ trades in complex credit derivatives ensured regulatory attention remained focused on derivatives trading.6 In the EU, additional concerns as to the potentially anti-competitive behaviour of major firms in the OTC credit default swap (CDS) market have kept policy attention trained on the derivatives markets.7

The financial stability agenda has also led to trading being drawn into the ongoing structural reform of the banking sector, which is designed to address the ‘too big to fail’ subsidy enjoyed by systemically significant banks which carry out household/commercial deposit-taking and lending functions along with wholesale market intermediation and dealing functions; deposit guarantees and the related ‘too big to fail’ subsidy have been associated with competitive advantage and with perverse risk-taking incentives in these banks. Ring-fencing and similar structural reforms, designed to reduce incentives for risk-taking by taking trading and other riskier activities outside the scope of deposit protection and of the implicit ‘too big to fail’ subsidy, to remove the related competitive advantage for large banks, to facilitate resolution, and to reduce the risk to the tax-payer8 are in train internationally, although they do not form part of the formal G20 reform agenda and reflect domestic initiatives and dynamics.9

(p. 513) Structural reform came to form part of the closing stages of the EU’s crisis-era reform programme, and was spearheaded by the 2012 Liikanen Group report10 and supported by the European Parliament.11 A related Commission Proposal for a regulation on structural measures supporting the resilience of EU credit institutions followed in early 2014.12 In order to curtail the artificial expansion of banks’ balance sheets, particularly through speculative activities; to reduce the risk of bank failure and tax-payer support; and to support efficient resolution where required, the Commission has proposed that a prohibition on ‘proprietary trading’13 and on investing in hedge funds apply to certain banks and entities within the same banking group (Article 6(1)); the proposal therefore requires the divestment of proprietary trading activities.14 The Commission has also proposed that certain ‘trading activities’ judged to be at risk of supporting illegal proprietary trading, or with a propensity to endangering financial stability (including market-making, investment in and sponsoring of securitizations, and the trading of certain derivatives), be subject to review by the relevant national competent authority (NCA), and to a subsequent separation requirement by the NCA15 where the NCA deems it necessary, in accordance with the proposed regime’s qualifying metrics and conditions (Articles 8–21);16 this requirement is designed to separate trading activities from deposit-taking within banking groups. The proposed prohibition regime would apply only (given its concern with mitigating financial (p. 514) stability risks) to the EU’s largest banks—those identified as Global Systemically Important Financial Institutions17—and banks with total assets exceeding €30 billion or with trading assets and liabilities in excess of €70 billion or 10 per cent of their total assets for three consecutive years.18 The proposed separation regime focuses in particular on ‘core credit institutions’.19 Overall, some 30 major banking groups are expected to be affected were the reforms to be adopted. Generating mixed reactions,20 and with a group-wide and extraterritorial reach designed to apply across an EU bank’s global corporate group,21 its fate is uncertain. While the ring-fencing proposals form part of the banking reform agenda and are focused on deposit-taking credit institutions and their groups, they nonetheless underline the close policy focus on the stability risks which trading can generate.

The EU trading reforms can also be associated with the highly politicized anti-speculation agenda which became an early feature of the crisis-era reform programme.22 It is not unexpected that crisis conditions would pull the trading process into the regulatory net; benign shareholders, traders, and risk managers can quickly become re-characterized as speculators and predators as the economic effects of crisis spread.23 As noted in Chapter I, the crisis era prompted a concern to monitor and manage financial innovation and generated some scepticism as to the benefit of ever higher levels of market intermediation and of market completeness achieved through the use of derivatives and, in particular, of speculative trading activities.24 In the UK, for example, the 2009 Turner Review called for regulatory policy to balance the benefits of market completion and market liquidity with (p. 515) the drawbacks of instability.25 Similarly, French regulatory policy since the financial crisis has focused on socially inefficient speculation.26 The Commission has also highlighted its commitment to reducing short-termism and speculative trading activities.27 The EU’s trading reforms reflect this concern to support ‘productive’ financial markets. But they have also been coloured by a sometimes febrile anti-speculation agenda which has an array of drivers, including long-standing suspicion of Anglo-American capitalism in some Member States, as well as the fiscal impact of turmoil in the EU’s sovereign debt markets.28 This dynamic is most apparent with respect to the new short selling rules, the algorithmic and high frequency trading (HFT) regime,29 and the proposed Financial Transaction Tax (FTT).

These different influences have combined to produce a trading regime which extends far beyond the original 2004 MiFID I conduct/prudential regime, and which now addresses short selling, algorithmic trading, and position management and includes a host of measures designed to strengthen the stability of OTC derivatives markets. It also applies to a wide range of financial market actors, including non-financial counterparties. The regime promises much, but it has troubling features. Chief among them are the potential risks to liquidity and effective risk management. Liquidity-constraining techniques were in use internationally pre-crisis, typically in the form of short selling curbs and, in some jurisdictions, transaction taxes; however, liquidity is generally promoted by regulators through, for example, disclosure techniques, insider-trading prohibitions, and trading market rules.30 A concern to protect liquidity is evident across the new trading regime, but liquidity-constraining techniques have also been deployed, notably in the form of short selling curbs, position-management powers, restrictions on algorithmic trading, and the proposed FTT. There are some indications that, reflecting the earlier and long-standing debate on the link between ‘excessive liquidity’ and ‘over-financialization’,31 and wider concerns that ‘excessive’ liquidity can generate financial instability,32 the EU regime seems concerned to drain excessive liquidity where it threatens financial stability. But attempts to drain liquidity from the market are fraught with risk, given the importance of liquidity to (p. 516) market efficiency. Particular dangers are associated with the new position limits regime for commodity derivatives trading and with the swingeing reforms to OTC derivatives market trading, given the costs being imposed as a result on hedging and risk-management practices. The pulling of trading by non-financial counterparties into the regulatory net is also potentially troublesome, given the related costs and potential prejudice to effective risk management.

As discussed throughout this Chapter, efforts have been made to calibrate the different rules to support liquidity and effective risk management (the trading venue regime discussed in Chapter V similarly seeks to ensure liquidity is protected, given the potentially prejudicial impact of the new trading venue rules—particularly those related to non-equity asset classes), notably with respect to the non-financial counterparties who use derivatives to hedge commercial risks and with respect to market-makers. In addition, the European Securities and Markets Authority (ESMA) brings a significant technical capacity to bear on the Binding Technical Standards (BTSs) (Regulatory Technical Standards (RTSs) and Implementing Technical Standards (ITSs)) and other administrative rules which will, in effect, operationalize the new regime. Nonetheless, the risks of unintended consequences are considerable. A further challenge relates to the fragmented nature of the regime: the derivatives regime, for example, is fractured across a number of measures, and close alignment between the 2014 MiFID II/MiFIR regime and the regime governing the OTC derivatives market, in particular, is imperative. Difficulties have, however, emerged in this regard (section 4.2.4).

VI.1.2  The EU Trading Regime

The EU trading regime is split across a number of measures. The 2014 MiFID II/MiFIR regime provides the overarching regulatory framework governing order execution (section 2). The 2012 Short Selling Regulation33 addresses short selling practices (section 3). The 2012 European Market Infrastructure Regulation (2012 EMIR)34 is the pivotal measure governing trading in the OTC derivatives markets, although an array of new requirements apply to this sector, including the trading venue obligation under MiFID II/MiFIR (section 4). The trading regime is also likely to include a new FTT, albeit that it will only apply within the ‘FTT zone’ of Member States which agree to implement it (section 5).

The trading regime also includes the universe of rules which govern market efficiency and transparency generally, including the rules governing market abuse and insider dealing considered in Chapter VIII, the reporting rules which require disclosure of certain equity positions (including positions in instruments of similar economic effect under the 2013 Amending Transparency Directive35—Chapter II section 5.7), and the transaction reporting and transparency rules which apply to trading activities under the 2014 MiFID II/MiFIR regime (Chapter V section 12.1). The focus of this Chapter, however, is on the subset of rules which focus specifically on the trading process. It does not address the (p. 517) regulation of the organized venues or platforms on which trading can occur, which is covered in Chapter V.36

Overall, the new trading regime is significantly deeper and wider than the pre-crisis regime. The extensive exemptions previously available to dealers have been scaled back (section 2). A much wider array of financial instruments have become subject to discrete trading rules, including OTC derivatives in general (section 4), commodity derivatives (section 2.5), and CDSs (section 3, with respect to short selling). The regime also deploys more intrusive tools. The new commodity derivatives regime, for example, deploys position-management tools, while the new short selling regime empowers NCAs and ESMA to impose a range of restrictions on short selling. Disclosure and reporting tools, long a feature of order-execution regulation, have been significantly expanded, notably with respect to short positions under the short selling regime and positions in commodity derivatives under the 2014 MiFID II/MiFIR.

The complexity, range, and ambition of the new regime calls for caution, particularly given the liquidity and risk-management risks previously noted. The new regime also demands much of the EU law-making process, particularly at the administrative/ESMA level, given the untested nature of many of the reforms. The new supervisory tools which have been made available at EU level (notably the short selling powers and the position-management powers for the commodity derivatives market) also demand much of supervision and, in particular, of ESMA, which has been conferred with exceptional powers of intervention with respect to position management and short selling (sections 2.5 and 3.9). Careful and holistic post-implementation review will be required.

VI.2  2014 MiFID II/MiFIR: The Regulation of Trading

VI.2.1  2014 MiFID II/MiFIR: Setting the Regulatory Perimeter—Scope and Dealing

The 2014 MiFID II/MiFIR regime provides the regulatory framework which governs the trading process generally. The generic MiFID II/MiFIR authorization, conduct, and prudential regime applies to the reception and transmission of orders, the execution of orders on behalf of clients, and dealing on own account,37 in each case in MiFID II/MiFIR financial instruments (MiFID II Annex I, section A).38 While some elements of the original MiFID I regime remain (notably the best execution and order handling requirements), MiFID II/MiFIR is significantly wider and more interventionist, reflecting institutional concern to upgrade MiFID I, close regulatory gaps, and implement the G20 reform agenda; the final trilogue (Commission/Council/European Parliament) negotiations, in particular, (p. 518) saw more intrusive regulation imposed, particularly with respect to algorithmic trading, market-making, and position management.39

Its scope, for example (as discussed further in Chapter IV), has extended. The exemption which applies to proprietary dealing activities (in financial instruments other than commodity derivatives, or emission allowances, or derivatives thereof) has been restricted, reflecting the G20 commitment to closing regulatory gaps.40 While under MiFID I the exemption required that the dealer not engage in market-making activities or deal on own account by executing client orders, MiFID II additionally requires that the dealer not be a member of or participant in a regulated market or multilateral trading facility (MTF) or engage in HFT (MiFID II Article 2(1)(d)).41 The related exemption for dealers in commodity derivatives, or emission allowances, or derivatives thereof similarly requires that the exempted dealer not engage in HFT (Article 2(1)(j)).42 More generally, dealers exempted under Article 2(1)(j), as well as the insurance undertakings and collective investment undertakings exempted from MiFID II and certain participants in the energy market, must, where they are participants of regulated markets or MTFs, comply with the new MiFID II requirements relating to algorithmic trading, HFT, and market-making (Article 1(5)).

VI.2.2  Regulating the Order-execution Process: the General Framework

VI.2.2.1  The 2014 MiFID II/MiFIR and the 2013 CRD IV/CRR Framework

The authorization and prudential regime which governs investment services/activities generally under the 2014 MiFID II/MiFIR regime (Chapter IV) applies to trading-related activities. So too do the 2013 CRD IV/CRR43 prudential requirements (for in-scope firms) governing internal risk management of counterparty, operational, liquidity, and market risk, and which are designed to strengthen incentives (regulatory and other) for prudent risk-taking (Chapter IV section 8). The CRD IV/CRR regime also addresses trading-related capital requirements and has delivered a series of enhancements, including with respect to counterparty credit risk and trading book risk, designed to support prudent risk-taking; extensive capital reforms are expected to apply to the market risk posed by trading portfolios under the trading book reforms under development by the Basel Committee (Chapter IV section 8.7).

Similarly, the MiFID II conduct regime applies to trading-related activities. Where a firm executes an order on behalf of a client (whether retail or professional), the conduct rules which govern the provision of investment services generally, and which include the anchor ‘fair treatment’ obligation (the obligation to act honestly, fairly, and professionally in accordance with the best interests of clients) and disclosure and record-keeping requirements (p. 519) (MiFID II Article 24) apply, as do the conflict-of-interest management requirements (Article 16(3) and Article 23). Where the transaction is executed between ‘eligible counterparties’,44 however, a lighter regime applies. Where an investment firm brings about or enters into transactions with eligible counterparties (essentially other regulated entities), the conduct regime does not apply (Article 30). The investment firm remains subject, however, to the conflict of interest regime and the disclosure elements of Article 24, and must act honestly, fairly, and professionally and communicate in a way which is fair, clear, and not misleading, taking into account the nature of the eligible counterparty and its business (Article 30(1)).

The conduct regime also contains a number of trading-specific requirements, which will now be discussed.45

VI.2.2.2  Best Execution

Best execution rules, which form part of conduct regulation and which address the agency risks of brokerage, can broadly be regarded as requiring execution intermediaries to seek the best possible result for their clients.46 While the ‘best possible result’ is often associated with price, it can reflect a range of other factors, including the reduction of market impact costs for large trades. Best execution also serves wider market efficiency functions, particularly where trading is fragmented across competitive order-execution venues, as it requires brokers to tie together execution data from different venues. Prior to the adoption of MiFID I, best execution regulation was not well developed across the EU,47 given the impact of the ‘concentration rule’ which, in the Member States where it applied, required retail orders to be routed through the local central stock exchange and, in effect, delivered a form of best execution by requiring the pooling of liquidity on exchanges. MiFID I, however, introduced a harmonized best execution obligation for retail and professional clients.48 As discussed in Chapter V, the competitive order-execution model imposed by MiFID I generated the risk that trading would become fragmented across multiple venues and that clients could become vulnerable to poor execution quality where intermediaries did not search across a sufficiently wide range of venues. The best execution regime was accordingly designed to ensure that the competitive benefits of a liberalized order-execution market were channelled to clients.49 The best execution requirement also provided a mitigant against the conflicts of interest inherent in the new competitive order-execution model. In particular, the ability of investment firms to ‘internalize’ client orders by trading with clients against their proprietary dealing books, and the removal of the obligation to (p. 520) route certain orders to stock exchanges, generated conflict-of-interest risks; the best execution obligation, together with the MiFID I fair treatment rules and conflict-of-interest management regime, was designed to protect clients against these prejudicial conflicts of interest.

The design of the MiFID I best execution obligation proved a challenge. As discussed in Chapter V, the MiFID I negotiations on the new competitive order-execution regime were febrile, given the re-allocation of trading benefits between exchanges and other venues which would follow MiFID I. The danger accordingly arose that the best execution requirement could have become a vehicle for favouring one or other class of trading venue. Best execution requirements are also, by their nature, technical and costly, and were all the more so in the new, liberalized MiFID I market, as execution intermediaries could have been required to review trading on and connect to a multiplicity of venues. In addition, poorly designed and overly prescriptive best execution requirements, which, for example, focus on a limited range of execution criteria, run the risk of restricting execution choices and of obstructing the development of competition between execution venues.50 Best execution obligations should reflect the dependence of best execution on a range of factors and accordingly be flexibly designed;51 these factors include the impact of trading costs, the importance of speed of execution (particularly where market impact costs arise), and the depth of liquidity, as well as the structure of the market (whether dealer or order-driven—see Chapter V on different market structures), the nature of the instrument (the best execution obligation engages very differently with equities as compared with customized derivatives), and the nature of the order. A flexible approach also allows multiple competing venues to compete on factors other than price—a price-based benchmark, for example, could have the effect of reinforcing the dominant position of incumbent venues where liquidity is deepest.

The MiFID I best execution obligation (composed of the MiFID I legislative regime and the administrative rules set out in the administrative 2006 Commission MiFID I Directive52 as well as Commission53 and Committee of European Securities Regulators (CESR) guidance54) has, however, been regarded as broadly successful and has not been significantly reformed by MiFID II. Difficulties did arise with respect to the ability of firms to achieve best execution, but these primarily reflected the poor quality of post-trade transparency data55 rather than the design of the best execution obligation. The MiFID I Review accordingly focused in the main on the quality of trading information flows to investment firms, rather than on the nature of the best execution obligation.

(p. 521) The 2014 MiFID II best execution regime, like the MiFID I regime, is based on a widely cast best execution obligation which is buttressed by execution policy, execution policy-monitoring, execution data collection, and disclosure requirements (MiFID II Article 27(1)). The regime also reflects client autonomy; where there is a ‘specific instruction’ from the client, the firm must execute the order following the specific instruction (Article 27). As under MiFID I, the best execution obligation applies generically to all trades in financial instruments, although it does not apply to transactions between investment firms and eligible counterparties (including through dealing on own account) (Article 30). It is not calibrated to different instruments, venues, and order handling processes, but leaves determination of the process for the achievement of best execution in particular circumstances to the firm.

Under Article 27(1), investment firms must take all ‘sufficient’56 steps when executing orders to obtain the ‘best possible result’ for their clients, taking into account price, costs, speed, likelihood of execution and settlement, size, nature, and other relevant considerations. In order to support the achievement of best execution, a new MiFID II obligation requires that for instruments which are subject to the trading venue obligation under MiFIR,57 each trading venue and systematic internalizer,58 and for other instruments each execution venue, makes publicly available—without charge—data relating to the quality of execution of transactions on that venue, on at least an annual basis, and including details on price, costs, speed, and likelihood of execution (Article 27(3)).59

In support of the core best execution obligation, investment firms must establish and implement ‘effective arrangements’, including an order-execution policy, to allow them to obtain the ‘best possible’ result in accordance with Article 27(1) (Article 27(4)). Best execution is therefore a function of a process rather than of a particular price benchmark. Disclosure is also deployed to support best execution; firms must provide information to their clients on their order-execution policy which explains clearly, in sufficient detail, and in a way that can easily be understood by clients, how orders will be executed (Article 27(5)); firms must also obtain the prior consent of clients to the execution policy (Article 27(5)). The investment firm must also inform the client where the order was executed (Article 27(3)). More generally, investment firms must summarize and make public on an annual basis (for each class of financial instrument) the top five venues (in terms of trading volume) where they executed client orders in the preceding year, and provide information on the quality of execution obtained (Article 27(6)).

(p. 522) Some prescription is imposed on the firm’s execution policy (and thereby on the firm’s execution practices) under Article 27(5), which requires that the policy include, in respect of each class of instrument, information on the different venues where the investment firm executes its client orders and the factors affecting the choice of execution venue. Firms must include those venues that enable firms to obtain on a ‘consistent basis’ the ‘best possible’ result for the execution of client orders. Reflecting the 2014 MiFID II/MiFIR concern that trading be organized on regulated trading venues (Chapter V), investment firms must inform clients where the order-execution policy provides for the possibility of client orders being executed outside a MiFID II/MiFIR trading venue and obtain the ‘prior express consent’ of clients before executing orders outside a trading venue.60 Article 27(1) specifies that where there is more than one competing execution venue (in accordance with the firm’s execution policy), in order to assess and compare the result for the client, the firm’s own commission and costs for execution must be taken into account in the assessment. A specific conflict-of-interest requirement applies: the firm must not receive any remuneration, discount, or non-monetary benefit for routing client orders to a particular venue which would be in breach of the MiFID II conflict-of-interest regime (Article 27(2)).

The more elaborate and complex the best execution policy, however, the greater the likelihood of costs being passed on to clients; the cost burden for retail clients, in particular, where extensive search costs are imposed on firms could become significant. The MiFID I administrative regime therefore established a price benchmark for best execution in the retail markets which has now been incorporated within the legislative text. Under Article 27(1), the best possible execution result for retail clients is to be determined in terms of the ‘total consideration’, representing the price of the instrument and the execution costs (including all expenses incurred by the client directly related to order execution).

Monitoring obligations apply. Article 27(7) requires firms who execute client orders to monitor the effectiveness of their execution arrangements and policy, and to identify and correct any deficiencies. The monitoring process must include an assessment, on a regular basis, of whether the execution venues included in the policy provide the best possible result for the client, and whether changes are required to firms’ execution arrangements (taking account of the information made publicly available under MiFID II on execution quality).

Clients may request the investment firm to demonstrate that their orders have been executed in accordance with the firm’s execution policy; investment firms must also be able to demonstrate compliance with the best execution regime to their NCAs on request (Article 27(8)).

The best execution regime is subject to an extensive delegation to administrative rule-making by the Commission (Article 27(9)); ESMA has additionally been empowered to propose RTSs relating to the new data collection and reporting requirements (Article 27(10)). The MiFID II administrative rulebook is likely to reflect the administrative 2006 MiFID I (p. 523) Directive, which amplified the best execution process and calibrated the best execution obligation to particular situations.

The 2006 Directive followed a flexible approach and set out in general terms the criteria according to which firms were to assess the relative importance of the different best execution factors, thereby eschewing a benchmark-based process—save in the retail markets (now incorporated into the legislative text). The extent of the obligation to select and connect to execution venues, given the potential costs—particularly for smaller brokers—caused very considerable difficulties during the negotiations on the MiFID I best execution regime, and led the Commission to clarify that the core obligation to take all reasonable steps to secure the best possible result was governed by reasonableness and did not require a firm to include all available execution venues in its policy;61 a ‘sufficient steps’ test now applies under Article 27(1), but a similar approach, injecting elements of reasonableness, is likely to be followed at the administrative level. The administrative rules did not, however, leave the firm with complete discretion: they set out, for example, the criteria to be taken into account in developing execution policies—the characteristics of the client (including whether retail or professional), the characteristics of the financial instruments, the subject of the order, and the characteristics of the execution venue to which the order could be directed (2006 Commission MiFID I Directive Article 44(1))—and imposed a non-discrimination obligation which required investment firms not to structure or charge their commissions in such a way as to discriminate unfairly between execution venues (2006 Commission MiFID I Directive Article 44(4)).

The administrative regime also addressed the particular best execution risks arising from portfolio management. Under MiFID I (as under MiFID II), the best execution obligation applied to the execution of orders. It did not, therefore, apply to the decision made by an asset manager to route an order to a particular broker for execution. CESR advised that the Article 19(1) ‘fair treatment’ principle (now MiFID II Article 24(1)) be used to support a discrete best execution regime, designed to address the application of best execution requirements to asset management. Accordingly, under Article 45(1) of the 2006 Commission MiFID I Directive, investment firms, when providing portfolio-management services, were to comply with the Article 19(1) obligation when placing orders generated by decisions to deal in financial instruments on behalf of clients with other entities for execution; Article 45(2) imposed the same obligation on firms which, when providing the service of reception and transmission of orders, transmitted client orders to other entities for execution. In order to comply with this overarching obligation, firms were to take all reasonable steps to obtain the best possible result for clients, taking into account the factors governing best execution (as amplified by the 2006 Commission MiFID I Directive); firms were also required to establish and implement a related best execution policy identifying, for each class of instrument concerned, the entities to which orders would be transmitted, to monitor and review this policy, and to provide related disclosures to clients (Article 45(4) and (5)). These firms were, accordingly, able to rely on the ability of the executing firm, (p. 524) once the choice of firm had been made in accordance with Article 45, to deliver best execution.62

Additional calibration was provided with respect to the application of the regime to dealer markets, through an informal MiFID I-related Commission document63 which responded to CESR’s request for clarification on the application of the obligation to markets where dealers provide continuous quotes either continuously, through an online or other limited-access venue, or bilaterally in response to a request for a quote.

VI.2.2.3  Order Handling

The 2014 MiFID II conduct regime also includes order handling rules. MiFID II Article 28(1) addresses the processing of investor orders and the management of conflicts of interest, and requires investment firms to implement procedures and arrangements which provide for prompt, fair, and expeditious execution of client orders, relative to other client orders and the trading interests of the investment firm. It also imposes a time-priority rule which requires firms to execute otherwise comparable orders in accordance with the time of their reception. These rules are designed to enhance confidence in the impartiality and quality of execution services in a competitive trading environment, particularly where retail orders are ‘internalized’ by investment firms.64

The delegations conferred on the Commission to adopt related administrative rules reflect the MiFID I delegations and so can be expected to lead to the adoption of rules similar to those in the 2006 Commission MiFID I Directive. Article 47(1) of the 2006 Directive required that firms comply with a series of overarching conditions when handling client orders. Orders were to be promptly and accurately recorded and allocated. Firms were to carry out otherwise comparable orders sequentially and promptly, unless the characteristics of the order or prevailing market conditions made this impracticable, or where the interests of the client required otherwise. They were also to inform retail clients about any material difficulties relevant to the proper carrying out of orders promptly upon becoming aware of the difficulty. Where the firm was responsible for overseeing or arranging the settlement of an executed order it was to take all reasonable steps to ensure that any client financial instruments or funds received in settlement of the executed order were promptly and correctly delivered to the account of the appropriate client (Article 47(2)). The risk of market abuse and the front running of orders was addressed by Article 47(3), which required that the investment firm not misuse information relating to pending client orders, and take all reasonable steps to prevent the misuse of such information by its employees and management.

Article 48 of the 2006 Commission MiFID I Directive imposed conditions on the aggregation and allocation of orders and required that aggregation and allocation occur only where it was unlikely that it would work, overall, to the disadvantage of any client whose order was to be aggregated, that disclosure of the risk of disadvantage be made to the (p. 525) client, and that an order-allocation policy be established and implemented which provided in sufficiently precise terms for the fair allocation of aggregated orders and transactions. Aggregation and allocation in the risk-prone context of own-account dealing was addressed under Article 49, which provided that where investment firms aggregated own-account transactions with client orders, the allocation was not to be made in a way detrimental to the client. In particular, where orders were allocated and the aggregated order only partially executed, the related trades were to be allocated to the client in priority over the firm. The order-allocation policy was also to cover aggregation of own-account orders with client orders.

VI.2.2.4  Trade and Transaction Reporting

All investment firms which conclude transactions in shares and equity-like instruments and in specified non-equity asset classes, either on own account or on behalf of clients, are subject to post-trade transparency requirements which require disclosure of trade data relating to the volume and price of the transactions and the time at which they were concluded; publication must be made through an ‘Approved Publication Arrangement’. Pre-trade transparency requirements apply only where the investment firm acts as a ‘systematic internalizer’ in that, on an organized, frequent, systematic, and substantial basis, it executes client orders by dealing on own account. Investment firms are also required to keep records on all orders and transactions in financial instruments which they have carried out (whether on own account or on behalf of clients), and to report complete and accurate details of all transactions executed in identified financial instruments to the relevant NCA as quickly as possible, and no later than the close of the following working day. These requirements relate in the main to the EU’s regulation of trading venues and of venue efficiency generally, and are considered in Chapter V.

Additionally, investment firms are subject to the general operational and organizational reporting requirements which apply under MiFID II/MiFIR. A trading-specific obligation is imposed by MiFID II which requires that the records kept by firms include mandatory recordings of telephone conversations or electronic communications relating to transactions concluded when dealing on own account, and the provision of client order services relating to the reception, transmission, and execution of client orders (MiFID II Article 16(7)).65

VI.2.3  Algorithmic Trading and High Frequency Trading

The MiFID I regime governing trading practices has been significantly expanded by the new regime which applies to algorithmic trading and HFT by investment firms.

HFT has its origins in the recent growth in electronic trading and in competition between trading venues, and in the related fragmentation of execution markets and generation of arbitrage opportunities, all of which are driving innovative trading technologies.66 It is a (p. 526) form of ‘algorithmic trading’, or automated trading based on sophisticated computer technology which dictates trading decisions and which takes advantage of arbitrage opportunities. HFT is latency (or speed of execution) sensitive. It is driven by computer programmes which interpret market signals and execute related trading strategies, and deploying high frequency orders (which are open often for less than a second and are typically market-neutral in effect), in order to take advantage of very short duration arbitrage opportunities; a range of techniques are used, including ‘co-location’ in, and ‘direct’/‘sponsored’ electronic access to, trading venues.67 It is typically engaged in by specialist dealers dealing against their own capital (high frequency traders) and is usually deployed to implement particular trading strategies (such as arbitrage, market-making, or short-term/news-driven directional strategies).68

The implications of HFT activity, which is significant in the EU,69 for market efficiency are contested. It can bring significant benefits to markets in the form of deeper liquidity (high frequency traders have come to act as quasi-market-makers by providing continuous ‘two-way’ (buy and sell) liquidity on major electronic order books70), narrower spreads, stronger price discovery, and better price alignment across venues;71 the liquidity benefits have led trading venues to create incentives in the form of liquidity-sensitive trading fees to support market-making.72 But risks can be generated, particularly where high frequency traders providing market-making functions withdraw in volatile market conditions and so contribute to a contraction of liquidity.73 Operational failures with respect to HFT can also threaten orderly trading, as suggested by the ‘Flash Crash’ on US trading venues on 6 May 2010.74 Related concerns have arisen as to whether trading venues have appropriately (p. 527) robust risk-management structures to deal with very high volumes of HFT. Doubts have also been raised as to whether real liquidity benefits are created, as HFT tends to lead to a decrease in trade order size rather than to new liquidity, can lead to other liquidity providers leaving the market, and can result in poor quality liquidity, volatility, and churning.75 HFT has also been linked with the growth of the dark OTC equity trading which became a major concern of the MiFID I Review of trading venue regulation; HFT trading has been associated with increased demand for dark OTC trading as a protection against the market impact risks which a trader unwinding a large position can face when high frequency traders are active.76 More generally, while HFT has attracted most attention, it forms only a subset of algorithmic trading generally, which is frequently deployed by investment firms to pursue proprietary dealing strategies as well as agency trading, and which demands careful operational oversight as it can generate the range of risks associated with HFT.77

The empirical evidence on the risks and benefits of HFT (and of algorithmic trading generally) is contested78 and the regulatory design challenges are considerable, not least with respect to how best to capture HFT and algorithmic trading efficiently within robust regulatory definitions. A reasonable case can, however, be made for closer regulatory attention,79 even if only to assess whether relevant risk management and market integrity rules are correctly applied to traders and venues and appropriately supervised, and to enhance regulatory intelligence on this form of trading. The financial stability implications of HFT, as well as the strong association between HFT and the wider crisis-era concern as to financial market intensity and innovation generally, made HFT a natural target, however, for the expanding crisis-era reform programme80 and for an interventionist approach.

(p. 528) In the EU, the approach adopted can be located at the more interventionist end of the spectrum.81 The first salvo was fired by ESMA, but its approach was relatively careful. One of ESMA’s first major initiatives outside the administrative rulebook was its 2011 guidelines for highly automated trading environments.82 The Guidelines, which are high-level in nature and systems- and controls-based, are closely based on MiFID I and provide guidance on how MiFID I’s operational requirements apply to ‘highly automated trading’ and in relation to trading venues and investment firms. The MiFID I Review, however, has led to a targeted and more intrusive legislative regime on algorithmic trading generally.

The new 2014 MiFID II regime has three strands: it provides for a new operational regime governing algorithmic trading by investment firms; it extends the scope of MiFID II to include all firms engaging in algorithmic trading and, in particular, specialist firms engaging in HFT; and it imposes new operational requirements on trading venues.83 Although the Commission, Council, and European Parliament were all in agreement on the need to bring algorithmic trading within the regulatory net, the negotiations proved contentious, with the Parliament, which had been hostile to HFT,84 adopting a more restrictive approach than the Council,85 particularly with respect to the regulation by trading venues of the HFT subset of algorithmic trading.86 Given the uncertain impact of restrictions on algorithmic trading, particularly with respect to liquidity levels when markets are disrupted and there are few incentives to provide liquidity,87 ESMA’s ability to calibrate the regime in order to minimize unintended consequences will have a significant influence on the effectiveness of this new and largely untested regime.

At the core of the new regime are the operational requirements governing ‘algorithmic trading’ generally (MiFID II Article 17), defined broadly as trading in MiFID II financial instruments where a computer algorithm automatically determines individual parameters of orders (such as whether to initiate the order, the timing, price, or quantity of the order, or how to manage the order after its submission), with limited or no human intervention (p. 529) (Article 4(1)(39));88 a subset of rules apply to ‘high frequency algorithmic trading’.89 MiFID II-scope investment firms engaging in algorithmic trading are subject to a targeted operational regime (Article 17(1)) which requires them to have in place effective systems and risk controls, suitable to the business operated, to ensure that trading systems are resilient and have sufficient capacity, are subject to appropriate trading thresholds and limits, and prevent the sending of erroneous orders or the systems otherwise functioning in a way that may create or contribute to a disorderly market. Effective systems and risk controls must also be in place to ensure the trading systems cannot be used for a purpose contrary to the market abuse regime or contrary to the rules of a trading venue to which the firm is connected. The firm must also have in place effective business continuity arrangements to deal with trading system failures, and must ensure its systems are fully tested and properly monitored to ensure compliance with MiFID II.

Regulatory reporting requirements apply, although the regime is proportionate and practical in that MiFID II does not require NCAs to approve the highly complex models used for algorithmic trading or firms to notify all such models. A firm that engages in algorithmic trading must notify the home NCA and the NCA of the trading venue at which the investment firm, as a member or participant, is engaged in such trading; the firm’s home NCA may require it to provide, on a regular or ad hoc basis, details of its algorithmic trading practices (Article 17(2)).90 The home NCA must communicate the disclosures received to any NCA of a trading venue at which the firm (as a venue member) is engaged in algorithmic trading on the request of such an NCA (Article 17(2)). Where a firm engages in high frequency algorithmic trading, it must also store, in an approved form, accurate and time-sequenced records of all its placed orders and make them available to the NCA on request (Article 17(2)).

Particular conditions (Article 17(3)), designed to protect market efficiency and avoid a sudden withdrawal of liquidity, apply where the firm engages in algorithmic trading pursuing a market-making strategy.91 In these circumstances the firm must engage in market-making continuously during a specified proportion of the trading venue’s trading hours, except under exceptional circumstances, with the result of providing liquidity on a regular and predictable basis to the trading venue.92 The firm must also enter into a binding (p. 530) written agreement between the investment firm and the trading venue which at least specifies the obligations of the firm with respect to market-making, and have in place effective systems and risk controls to ensure it can at all times fulfil its market-making obligations. The conditions apply taking into account the liquidity, scale, and nature of the specific market, and the characteristics of the instruments traded.

The regime also imposes specific controls on firms which, as members of trading venues, provide direct electronic access93 by clients (in effect, high frequency traders) to the venues. These controls, inter alia, require that effective systems and controls are in place, that clients are subject to pre-set trading and credit controls, that client trading is monitored, and that risk controls apply to prevent client trading that could generate risks for the firm or create or contribute to a disorderly market—direct electronic access without such controls is prohibited, and firms are also responsible for ensuring that these clients comply with MiFID II and the rules of the trading venues and must monitor transactions to identify breaches of rules (Article 17(5)).94

The regime is to be expanded by RTSs governing the organizational requirements (including the requirement for a written agreement governing market-making) and the technicalities of the regime (Article 17(7)).

In tandem with these targeted rules, the scope of MiFID II has been extended to capture proprietary dealers who engage in HFT, reflecting the structure of the HFT industry. The exemptions which apply to proprietary dealers do not apply where the person in question applies a high frequency algorithmic trading technique (Article 2(1)(d) and (j)). In addition, the Article 17 regime applies to members or participants of regulated markets or MTFs who are not required to be authorized under MiFID II by virtue of the exemptions for insurance undertakings, collective investment undertakings, and certain energy market participants.95

The regulatory regime for investment firms extends beyond MiFID II, with the new market abuse regime including examples of when algorithmic trading and HFT would amount to market manipulation (Chapter VIII section 8.2.2).

(p. 531) VI.2.4  Market-making

The sensitivity towards market liquidity which is implicit in the new regime governing algorithmic trading is also evident in the attention which the 2014 MiFID II regime gives to market-making96 (MiFID I did not address market-making and the related risk/reward dynamics and appropriate regulatory supports). Firms engaging in market-making activities cannot be exempted under the MiFID II exemptions for proprietary dealers in instruments other than commodity derivatives, emissions allowances, and related derivatives (Article 2(1)(d)). Specific controls apply where market-makers use algorithmic techniques to engage in market-making, as noted in section 2.3 of this Chapter. The most extensive regulation applies at the trading venue level. As noted in Chapter V section 7.3, MiFID II/MiFIR trading venues must have in place market-making agreements with firms pursuing market-making strategies (the contents of which are subject to minimum conditions) and have schemes in place to ensure that a sufficient number of firms participate in such agreements, which agreements require them to post firm quotes at competitive prices with the result of providing liquidity to the market on a regular and predictable basis, where such a requirement is appropriate to the nature and scale of the trading on that venue (Article 48(2) and Article 18(5)).97 Similarly, MTFs and organized trading facilities (OTFs)98 must have at least three materially active members or users, each having the opportunity to interact with all the others with respect to price formation (Article 18(7)).

VI.2.5  Position Management and Trading in Commodity Derivatives

VI.2.5.1  The Commodity Derivatives Agenda

An extensive new position-management regime applies to trading in commodity derivatives under the 2014 MiFID II/MiFIR regime.

As noted in Chapter IV section 4.3, commodity derivative trading and related investment services came within the regulatory net under MiFID I, albeit that exemptions were available for commercial firms deploying commodity derivatives to hedge commercial risks. The regime governing trading in commodity derivatives has become significantly more intrusive over the crisis era. This reflects the expanding perimeter of EU securities and markets regulation and the wider G20 agenda to address unregulated sectors, but it also reflects an international policy concern as to the potentially destabilizing impact of trading by financial institutions in commodity derivatives on world commodity prices. In recent years, concerns have grown as to the increasing volume of trading in commodity derivatives by financial institutions (particularly through commodity index funds) on key benchmark commodity derivatives markets (notably for oil and agricultural products). This trading has (p. 532) been associated with increasing commodity prices and volatility,99 technical difficulties with pricing dynamics on these markets, and threats to market integrity.100 Commodity derivatives market efficiency and integrity subsequently became entwined with the global crisis-era reform agenda, with the September 2009 Pittsburgh G20 Summit committing to improve the regulation, functioning, and transparency of financial and commodity markets to address excessive commodity price volatility,101 and a related International Organization of Securities Commissions (IOSCO) agenda following.102

The related EU agenda has a number of elements,103 including the EMIR-related strengthening of derivatives markets (section 4.2), the new controls on short selling, which also address trading in commodity derivatives (section 3), and the 2014 MiFID II/MiFIR tightening of the exemptions from regulation for commodity and commodity derivatives dealers (Chapter IV section 5.1). It also includes tighter regulation of the organized trading venues on which commodity derivatives are traded (as these markets tend to set the price benchmarks and to serve as the major price discovery channels for commodity prices), mainly through the new 2014 MiFID II/MiFIR position reporting and position-management/control regime.

The new MiFID II/MiFIR regime applies in relation to 2014 MiFID II/MiFIR trading venues and to persons trading in commodity derivatives, whether or not they are otherwise exempted from MiFID II/MiFIR,104 and in relation to commodity derivatives generally.105 It is accordingly cast in broad terms given the different dynamics of different types of commodity derivative and trading venue. It has four elements: NCA powers in relation to persons trading in commodity derivatives; related ESMA powers; trading venue position-management powers; and reporting obligations imposed on trading venues and persons.

(p. 533) VI.2.5.2  NCA Powers

The 2014 MiFID II has introduced mandatory new harmonized powers for NCAs for controlling trading on commodity derivatives markets, primarily in the form of the intrusive power to set and impose position limits.106 Reflecting the novelty and risks of the new regime and the concern to avoid distortions opening up between different markets and between the spot and derivatives markets, NCA discretion is tightly controlled by the extensive RTSs which will govern this area and by the different ESMA-based devices used to ensure NCAs operate within the harmonized regime. Similarly, the delegations to RTSs are detailed, and include injunctions to ESMA to take into account market and regulatory experience with such limits.

At the heart of the new regime is the highly contested position limit requirement (MiFID II Article 57).107 NCAs, in line with the calculation methodology to be determined by ESMA, must establish and apply position limits on the size of a net position which a person can hold at all times in commodity derivatives traded on trading venues108 and in economically equivalent OTC contracts (Article 57(1)). The limits must be set on the basis of all positions held by a person (and those held on its behalf at an aggregate group level) and in order to prevent market abuse and to support orderly pricing and settlement conditions, including preventing market-distorting positions and ensuring convergence between the pricing of derivatives in the delivery month and spot prices for the underlying commodity, without prejudice to price discovery in the market for the underlying commodity (Article 57(1)). The limits must specify clear quantitative thresholds for the maximum size of the position in a commodity derivative that a person can hold (Article 57(2)). In the formula repeatedly used across crisis-era EU derivatives market regulation in order to protect commercial hedging activities,109 positions limits must not apply to positions held by or on behalf of a non-financial entity and which are objectively measurable as reducing risks directly related to the commercial activity of that non-financial entity (Article 57(1)). RTSs will govern the methodology to be applied by NCAs in establishing the spot month position limits and other position limits for physically settled and cash settled commodity derivatives, based on the characterization of the relevant derivatives.110

(p. 534) In addition, NCAs must set limits for each contract in commodity derivatives traded on trading venues (and including economically equivalent OTC contracts), based on the methodology developed by ESMA for person-related limits (Article 57(4)). As commodity derivatives trade across different venues, a mechanism applies to allocate primary responsibility for determining the single position limit to be applied to all trading in a contract where the same commodity derivative contract is traded in ‘significant volumes’ on trading venues in more than one jurisdiction; in effect, the limit-setting responsibility lies with the NCA of the venue where the largest volume of trading takes place, but this NCA must co-ordinate with other relevant NCAs (Article 57(6)). NCAs are also to put in place co-operation arrangements, including with respect to the exchange of data to enable monitoring and enforcement of the single position limit.

In an indication of the concern to ensure this novel and interventionist regime is sensitive to market dynamics, NCAs must review position limits whenever there is a significant change in deliverable supply or in open interest, or any other significant change in the market, and reset the limits in accordance with the ESMA methodology (Article 57(4)).

NCAs can impose more restrictive position limits than those established ex ante, but only in exceptional cases, where the action is objectively justified and proportionate, taking into account the liquidity and the orderly functioning of the specific market (Article 57(13)).

Generally, position-management limits and controls must be transparent and non-discriminatory, specify how they apply, and take into account the nature and composition of market participants (Article 57(9)).

ESMA is injected into the new position limit process across a number of dimensions, and is to bring expert capacity, as well as operational consistency and convergence, to the regime. It will develop the RTSs governing the pivotal position-limit-setting methodology (Article 57(3). It must also propose an array of other RTSs, including with respect to the scope of the obligation (including with respect to whether a position qualifies as reducing risks directly related to commercial activities, the aggregation determination, and whether a contract is economically equivalent) and the procedure for determining the venue on which the largest volume of trading takes place (Article 57(12)). It is also empowered to review position limits (Article 57(5)). NCAs are to notify ESMA of the exact position limits they intend to set; within two months, ESMA must provide an opinion assessing the compatibility of the limits with the objectives of the position limits regime and with the position-limit-setting methodology. An NCA must modify its limits in accordance with the opinion or provide ESMA with a justification as to why change is not considered necessary; where an NCA imposes limits contrary to an ESMA opinion, it must immediately publish on its website its reasons for doing so. Similarly, where an NCA imposes more restrictive position limits in exceptional cases, ESMA must offer an opinion as to whether the limits are necessary; where an NCA imposes limits contrary to the opinion, it must immediately publish its reasons on its website (Article 57(13)). ESMA is also to monitor, at least (p. 535) annually, how NCAs have applied the position-limits-setting methodology (Article 57(7)). Where ESMA determines that an NCA position limit is not in accordance with the methodology, it must take action in accordance with its breach of EU law powers under 2010 ESMA Regulation Article 17 (Article 57(5)).111 With specific reference to contracts traded pan-EU, it is empowered to engage in binding mediation where NCAs cannot agree on a single position limit (Article 57(6)), and is to ensure that a single position limit effectively applies to the same contract, irrespective of where it is traded (Article 57(7)). More generally, it is to perform a facilitation and co-ordination role in relation to NCA action on positions and to ensure a consistent approach is taken by NCAs (2014 MiFIR Article 44(1)).

NCAs are also empowered generally to take specific supervisory/enforcement position-management action to require or demand the provision of information from any person regarding the size and purpose of a position or exposure entered into via a commodity derivative, and any assets or liabilities in the underlying market (Article 69(2)(j)); and, dovetailing with Article 57, to limit the ability of any person from entering into a commodity derivative, including by introducing limits on the size of a position in accordance with Article 57 (Article 69(2)(p)).112

VI.2.5.3  ESMA Powers

In addition to its quasi-regulatory and convergence/co-ordination powers, ESMA has—more radically—been conferred with direct position-related powers, akin to the powers it can deploy in relation to product intervention (Chapter IX 7.1) and with respect to short selling (section 3.9.2) under the 2014 MiFIR (Article 45). These powers proved controversial over the negotiations, reflecting Member State concern in some quarters that these powers breached the prohibition on the conferral of discretionary powers on EU agencies.113

These powers are not specific to commodity derivatives but apply to all derivative positions, although the regime focuses in particular on commodity derivatives. ESMA may directly request all relevant information regarding the size or purpose of a position or exposure entered into via a derivative from any person; require any such person to reduce the size of or to eliminate the position or exposure; and ‘as a last resort’ limit the ability of a person to enter into a commodity derivative transaction (MiFIR Article 45(1)). These measures take precedence over any MiFID II Article 69(2)(p) (commodity derivative-specific) or (0) (general) measure (section 2.6) adopted by the NCA (Article 45(1) and (9)).

As is the case with its product intervention and short selling powers, and to ensure compliance with the Meroni doctrine which prohibits ESMA from exercising discretionary (p. 536) powers and accordingly requires that conditions apply to confine discretion,114 a series of conditions apply to the exercise of these powers. The ESMA measures must address a threat to the orderly functioning and integrity of financial markets, including commodities derivatives markets in accordance with the MiFID II Article 57 objectives and including in relation to delivery arrangement for physical commodities, or to the stability of the whole or part of the financial system in the EU. In addition, either an NCA or NCAs must not have taken measures to address the threat, or the measures taken must have not sufficiently addressed the threat. ESMA must also ensure that the measures taken meet a set of conditions.115 Administrative rules116 will specify further the conditions which apply to these powers.117 ESMA must notify the relevant NCAs before imposing or renewing118 any measures.119

VI.2.5.4  Trading Venue Requirements

The regime cascades to the MiFID II/MiFIR trading venues which trade commodity derivatives, which are required to have in place position-management controls (MiFID II Article 57(8)–(10)).120 These powers must include, at least, powers for the trading venue to: monitor the open interest positions121 of persons; access information relating to positions;122 require the termination or reduction of a position, on a temporary or permanent basis, and to act unilaterally where the position holder does not comply; and, where appropriate, require a person to provide liquidity to the market at an agreed price and volume on a temporary basis with the intent of mitigating the effects of a large or dominant position. Position-management controls must be transparent and non-discriminatory, (p. 537) specify how they apply, and take into account the nature and composition of market participants.

VI.2.5.5  Position Reporting

Finally, a new position reporting regime applies to commodity derivatives (MiFID II Article 58). Trading venues which trade commodity derivatives (or emission allowances or derivatives thereof) must make public a weekly report123 which sets out the aggregate positions held by different categories of persons for the different commodity derivatives (or emission allowances or derivatives thereof) traded on the venue, the number of long and short positions (by category of persons holding positions), changes from the previous report, the percentage of total open interest represented by each category, and the number of persons holding a position in each category (Article 58(1)).124 This report must be communicated to the NCA and ESMA (Article 58(1)).125 In addition, trading venues must provide to the NCA a complete breakdown of the positions held by all persons—including venue members or participants and their clients—on the venue, on at least a daily basis (Article 58(1)).

With respect to firms trading in commodity derivatives or emission allowances or derivatives thereof outside a trading venue (OTC trading), these firms must provide the NCA of the trading venue where the relevant commodity derivatives (or emission allowances or derivatives thereof) are traded (or the NCA where the instruments are traded in significant volumes, where more then one jurisdiction is engaged) on at least a daily basis with a complete breakdown of their positions taken in these instruments traded on a trading venue and in economically equivalent OTC contracts, as well as those of their clients and the clients of those clients until the end client is reached (Article 58(2)).126

To support monitoring of the Article 57 position limits regime, members or participants of regulated markets and MTFs, and clients of OTFs, must report to the investment firm or market operator operating the trading venue in question the details of their own positions held through contracts traded on the trading venue, on at least a daily basis (Article 58(3)).127

The categories of persons against which the reporting obligation applies are designed to allow NCAs to monitor the nature of trading, particularly the nature and prevalence of trading by financial institutions, and include authorized investment firms and credit institutions, investment funds (under the Undertakings for Collective Investment in Transferable Securities (UCITS) or Alternative Investment Fund Managers Directive (AIFMD) regimes),128 other financial institutions (including insurance undertakings), (p. 538) commercial undertakings, and identified participants in the EU’s emission allowances regime (Article 58(4)).

The reporting regime is to be amplified by ITSs governing the format of the trading venue reports to be provided by venue participants, and by administrative rules governing the thresholds below which the venue reporting obligation does not apply (having regard to the total number of open positions and their size, and the total number of persons holding a position).

VI.2.6  General Position Management

In addition to the commodity derivatives-related powers, MiFID II also requires, more generally, that an NCA be empowered to request any person to take steps to reduce the size of a position or exposure (whether or not in commodity derivatives) (Article 69(o)).129 As noted in section 2.5.3 of this Chapter, ESMA can also exercise general position-management powers.

VI.3  The Regulation of Short Selling

VI.3.1  The EU Regime

The EU’s regulation of trading includes a discrete short selling regime which came into force in 2012. The new short selling regime is composed of five legislative and administrative measures. The legislative 2012 Short Selling Regulation130 has been amplified by four administrative measures: the 2012 Commission Delegated Regulation 918/2012, which contains the majority of the administrative rules;131 the 2012 Commission Delegated Regulation 826/2012;132 the 2012 Commission Delegated Regulation 919/2012;133 and the 2012 Commission Implementing Regulation 827/2012.134 The regime as a whole applied from 1 November 2012.

(p. 539) VI.3.2  Regulating Short Sales and the Financial Crisis

Short selling involves the selling of a security (typically a share) which the seller does not own with the objective of buying the security prior to the delivery date;135 it is usually achieved through derivatives or by short sales in the cash market. Where a short sale is ‘uncovered’ or ‘naked’, the seller does not borrow the security or enter into an agreement to secure its availability.136 Short sales serve a number of purposes, including with respect to speculation, hedging and risk management, arbitrage, and market-making. Short selling can also be carried out through CDSs which fulfil similar economic functions to short sales in that they pay the CDS buyer a fee on a decrease in value of the covered (reference) security (corporate and sovereign bonds).137

It has long been assumed that short sales support market liquidity through the trades in which the short seller engages, and that they support efficient price formation by correcting over-pricing;138 the series of autumn 2008 prohibitions internationally on short selling provided extensive evidence of the damage which prohibitions on short sales in shares can wreak on liquidity and on the efficiency of price formation.139 Short sales can also act as hedging and risk-management devices, allowing the short seller to hedge against price decreases in long positions.140 This is particularly the case with CDSs, which provide a risk-management function where liquidity is thin in the underlying bond market.141 CDSs also support liquidity in the sovereign debt markets by standardizing the risk associated with different issues of debt through a single and interchangeable CDS contract.

(p. 540) Prior to the financial crisis, a number of market efficiency risks had, however, been associated with short sales,142 including CDS transactions. Chief among these are the potential short sales have for driving negative price spirals which can lead to disorderly markets and systemic risks; the lack of transparency associated with short sales and the related potential for manipulative conduct and inefficient pricing; and the particular risk of settlement failure143 and speculation144 associated with uncovered short sales, where the short seller carries the risk of being unable to close the short position, particularly in illiquid conditions.145 The crisis era exposed how short selling can contribute to financial instability where negative selling pressure in the securities of a financial institution risks destabilizing an institution and, in conditions of acute market volatility and instability, can generate systemic risks. In addition, poor transparency can hobble regulators in assessing the scale and location of risks to financial stability and market efficiency.

The regulatory toolbox for short sales includes transparency and reporting requirements (including flagging requirements for short sale orders and individual position reporting requirements); conditions on short sales (including ‘locate’ rules, which are used to determine whether a short sale is covered and so permitted,146 and ‘tick’ rules, which govern when short sales can occur);147 and prohibitions (including ‘circuit-breaker’ rules which automatically halt trading when prices fall below a set threshold in a set time and prohibitions on uncovered short sales).148 In the EU, short selling regulation was not common prior to the financial crisis, which has led to a dearth of empirical evidence on short sales149 and on how to design an optimal regulatory response.

Short selling regulation underwent something of a transformation over the financial crisis as securities and markets regulators worldwide turned to it as a means for supporting financial stability—although it is hard to avoid the impression that a concern to be ‘seen to act’ and (p. 541) to take visible action was also a factor.150 Certainly, securities and markets regulators worldwide, who had traditionally relied heavily on disclosure tools,151 had little experience of, and a limited toolbox for dealing with, the massive instability which shook financial markets in autumn 2008.152 However counterintuitive for regulators who traditionally had not intervened in trading, trading-related regulation was one of the very few tools which could be quickly deployed to support financial stability153—however blunt and ineffective a tool it subsequently turned out to be.154 In the US, for example, the Securities and Exchange Commission (SEC) imposed a temporary prohibition on short sales in the shares of 799 financial institutions on 18 September 2008.155 On the same day in the UK, the (then) Financial Services Authority (FSA) announced a temporary prohibition on short sales in the shares of 32 financial institutions and related reporting requirements,156 while similar action was taken by a range of different NCAs across the EU (section 3.3). Australia similarly prohibited short sales on 19 September 2008, although its prohibition originally extended to all listed securities.157 Short selling did not, however, become a major priority for the G20-led reform agenda. IOSCO subsequently adopted principles on the effective regulation of short selling in response to the action taken worldwide in autumn 2008 and in order to assist regulators and restore and maintain investor confidence, but the principles operate at a high level of generality and did not attract significant political traction.158

In the EU, the financial crisis saw the regulatory treatment of uncovered CDS transactions, and particularly CDSs on sovereign debt, also become drawn into the short selling reform agenda; prior to the crisis, the regulation of short selling internationally—to the extent it occurred—was associated with the equity markets and with supporting market efficiency. CDSs are strongly associated with hedging and risk-management activities, and with the (p. 542) allied support of bond market liquidity. But, as CDS trading is thought to have a strong impact on bond pricing, volatility in the CDS market (particularly where that market is concentrated and cannot quickly respond to demand) can have strong negative effects on bond pricing where bond investors (particularly in illiquid markets) rely heavily on CDS pricing.159 The structure of a CDS also heightens the speculation risks associated with short selling generally; where the CDS holder does not hold an insurable interest against which the CDS hedges, the holder has strong incentives to drive a default or price decrease against which the CDS pays out.

But intervention in the CDS market, and in the sovereign CDS market in particular, is fraught with risk. CDS trading generally occurs in the global OTC markets; an effective prohibition requires close international co-ordination. Empirical evidence is limited. The empirical evidence as to a link between speculative uncovered trading in sovereign debt CDSs and volatility and instability in sovereign debt markets, for example, is not strong,160 and it is now clear that the sovereign debt CDS market did not expand materially over the financial crisis.161 Intervention can bring significant risks to liquidity in the sovereign debt markets, in particular, and to the efficiency with which sovereigns can manage deficits. Similarly, risk management can be prejudiced where market reliance on sovereign CDSs to hedge against a range of assets and liabilities, often on a cross-border basis, is curtailed.162

While there were some early indications of appetite for a co-ordinated international response to the treatment of CDSs,163 the international ‘speculation’ agenda became largely concerned with the treatment of OTC derivatives and related clearing and venue-trading obligations, and moved away from short selling. The EU agenda, however, became highly politicized and closely associated with addressing the impact of short selling and CDS trades on the troubled sovereign debt market.

(p. 543) VI.3.3  The Evolution of the EU’s Response

VI.3.3.1  Initial Developments

Three proximate drivers can be identified for the 2012 Short Selling Regulation: concerns as to regulatory fragmentation and arbitrage consequent on the unilateral and divergent prohibitions on short sales taken by the Member States initially in autumn 2008; a wider concern in some Member States, and particularly in the European Parliament, with respect to perceived excessive speculation and levels of financial market intensity and intermediation; and concerns, notably among the French and German governments, as to speculation in the sovereign debt markets, particularly through the use of CDSs, and as to the consequent pressure on the stability of the euro area and on Member States’ ability to raise funds and manage deficits.

Short selling erupted on to the EU agenda in autumn 2008 when a number of Member States (not all)164 imposed restrictions of varying types on short sales,165 in an effort to shore up financial stability. Three forms of restriction or condition (which typically, although not always, applied to the shares of identified financial institutions) were used: disclosure requirements related to short positions;166 prohibitions on naked short sales;167 and prohibitions on short sales generally.168 No Member State, until Germany’s shock action in May 2010 (noted further on in this section), imposed restrictions on CDS transactions.

The first reform proposal169 came in July 2009 with CESR’s consultation on a pan-EU transparency regime relating to short positions,170 which was adopted by CESR members in March 2010.171 The regime, which is reflected in the 2012 Short Selling Regulation, applied to shares only, and recommended disclosure to NCAs where a short position amounted to 0.1 per cent of the issuer’s share capital and public disclosure at 0.2 per cent, as well as disclosure at specified incremental steps thereafter.

Political and market conditions intervened in spring 2010 to place more radical regulatory measures on the agenda. Turmoil in the Greek sovereign debt market172 fuelled political (p. 544) concerns that speculation in sovereign debt CDSs—in effect, speculation on the likelihood of default—was prejudicing the stability of Member State sovereign debt markets and of the euro area, and damaging the ongoing, strenuous, and politically costly efforts to stabilize the euro area. In March 2010, France and Germany (supported by Luxembourg and Greece) called on the Commission to investigate the effect of speculative trading in CDSs on the sovereign bonds of Member States, to introduce transparency requirements, and to prohibit trades in uncovered CDSs.173 Ongoing instability led to Greece introducing additional short selling measures in April 2010.174 Germany’s decision to prohibit short selling and CDS transactions in May 2010,175 which was taken without notification of the Commission or of other Member States, materially ratcheted up the political tensions176 and the pressure for intervention.177 It also exposed differences between the Member States as to the optimal approach to short selling (France, in particular, was critical of Germany’s unilateral approach), significantly increased tensions between Member States as global equity markets and the value of the euro tumbled in the wake of Germany’s action, and generated a call for greater co-ordination from the Financial Stability Board (FSB). The parallel and febrile negotiations on the AIFMD Proposal, and the association between hedge fund activity and short selling,178 ratcheted tensions up further; the June 2010 recommendation from the European Parliament’s economic and monetary committee (ECON) that all naked short sales by fund managers within the proposed AIFMD regime be prohibited underlined the extent of political and institutional hostility to short selling.179 June 2010 also saw France and Germany take legislative action with respect to short sales.

In this febrile environment, and with consensus on the need to avoid further unco-ordinated action, as well as a strong anti-speculation agenda in some Member States,180 the Commission engaged in a short consultation181 before publishing its Proposal (along (p. 545) with the EMIR Proposal) in September 2010. The adoption by the Commission of the Proposal can be strongly associated with the prevailing political climate;182 Commissioner Barnier, for example, linked the Proposal with efforts to restrain any ‘wild west’ tendency in financial markets.183

VI.3.3.2  The Negotiations

Despite the rhetoric which attended it, the Commission’s Proposal was less interventionist than the 2012 Regulation as finally adopted. The Short Selling Proposal was deeply rooted in the crisis-era experience, and accordingly responded to the fragmentation and regulatory arbitrage risks which the Commission associated with the diverging Member State responses to short selling, as well as to the potential for short selling to lead to systemic risks unless transparency was improved and riskier uncovered transactions prohibited.184 Although less concerned with the international regulatory agenda than the AIFMD Proposal (which had similar drivers in relation to controlling speculation), the Proposal was also designed to ensure the EU regime did not lag the recently reformed US regime.185 It proposed a transparency regime for short sales in shares based on CESR’s model, but extended this model to apply to short sovereign debt positions. It proposed prohibitions on uncovered short sales and on uncovered sovereign debt short sales. It also proposed direct intervention powers for NCAs and for ESMA. All of these elements, albeit significantly nuanced, can be found in the 2012 Short Selling Regulation. The Proposal differed from the Regulation, however, by extending the transparency regime from position reporting to order reporting, through a requirement that all short-sale-related sell orders on trading venues within the scope of the Proposal be ‘marked’ as short sales, and that venues provide a daily summary of the volume of short sale orders. Most significantly, it did not contain a prohibition on uncovered sovereign CDS transactions; instead, it subjected these transactions to a position reporting requirement.

Although the industry warned of the risks of restricting CDS transactions,186 the European Parliament, which was concerned as to speculation in the sovereign debt markets,187 tightened the Commission’s text by introducing a prohibition on uncovered sovereign CDS trades, although it provided a more facilitative and nuanced definition than the Commission’s Proposal of the nature of a ‘covered’ trade. The Parliament also lightened the Commission’s transparency regime by replacing the reporting requirement relating to short sale orders with a requirement that the daily transaction reports required of trades in in-scope financial instruments include an indication as to whether a transaction was a short sale.

(p. 546) The European Parliament’s prohibition on uncovered CDS transactions quickly became a major point of contention with the Council; through its July 2011 negotiating position, it signalled its determination not to allow the Council a veto in this regard.188 Internal Council negotiations also proved very difficult, with the Council split between the Member States (the majority) which opposed intervention in the sovereign debt market, given the potential damage to the ability of Member States to raise finance (the most vehement opponents were reportedly the Netherlands, Poland, Italy,189 the UK,190 and Luxembourg), and the minority of Member States (including France and Germany) concerned to quell speculation in sovereign debt.191 ESMA’s emergency intervention powers also proved controversial (section 3.9.2). A negotiating position was finally reached by the Council in May 2011 which included a provision providing for a temporary suspension of the prohibition on uncovered short sales in sovereign debt and on uncovered sovereign CDS transactions where sovereign debt markets were disrupted; a more facilitative approach to the characterization of a short sale as ‘covered’; and the removal of daily reporting obligations. Very difficult trilogue negotiations followed, with deadlock for some time between the Council and the Parliament on the treatment of the sovereign debt market and of uncovered sovereign CDS transactions.192 Tensions were exacerbated by ongoing turmoil in the markets, which underlined the divergent views across the Member States and within NCAs as to the appropriate treatment of short selling. On 11 August 2011—as rumours regarding the health of French banks swept EU markets, borrowing costs increased, and emergency financing levels increased—four Member States, supported by ESMA, imposed or extended temporary prohibitions on short selling, which varied in scope.193 But the Dutch NCA (the AMF) stated that a prohibition was not necessary, and the majority of the EU’s NCAs did not act.194 After difficult negotiations, the Council’s modifications to the Parliament’s outright ban on uncovered sovereign CDS transactions were finally accepted,195 (p. 547) including those relating to when a sovereign CDS would qualify as ‘covered’ and so would be permitted.196 A joint text was finally agreed in November 2011.

VI.3.3.3  The Short Selling Regulation

The short selling regime takes the form of a regulation in order to ensure uniform application197 and to allow for the conferral of powers on ESMA. The Regulation is designed to lay down a common regulatory framework with regard to the requirements and powers relating to short selling and CDSs, and to ensure greater co-ordination and consistency between Member States.198 The objectives of the Regulation are to: increase the transparency of short positions held in certain securities; ensure Member States have clear powers to intervene in exceptional situations to reduce risks to financial stability and to market confidence arising from short sales and from CDSs; ensure co-ordination between Member States and ESMA in adverse situations; reduce settlement and other risks linked with uncovered short selling; and reduce the risks to the stability of sovereign debt markets posed by uncovered CDS positions.199 Accordingly, it imposes two sets of obligations on market participants (first, a prohibition on uncovered transactions; second, transparency requirements) and confers a range of powers on NCAs and ESMA.

VI.3.3.4  A Workable Regime?

The crisis-era series of prohibitions and restrictions on short selling internationally has attracted voluminous critical comment.200 In the EU, the adoption of an effective harmonized regime, or at least a regime which did not unduly prejudice market liquidity, pricing, and risk-management dynamics, faced significant obstacles.201 The legislative process was highly politicized and often febrile. The empirical evidence which could have mitigated political risks and supported nuanced drafting was limited. While the crisis produced extensive evidence on the impact of prohibitions on short sales in equity202 (although opinion differed widely as to whether and how uncovered equity short sales (p. 548) should be restricted),203 the empirical evidence on prohibitions on sovereign debt short sales and on sovereign CDSs transactions was very limited (only in relation to the German prohibition).204 Similarly, while some evidence was available on the impact of reporting requirements for short positions (particularly with respect to shares), it was generally limited and did not extend to reporting on sovereign debt and CDS positions.205 The Commission’s Impact Assessment was thinly evidenced206 and precautionary, particularly with respect to the sovereign debt and CDS measures.207 It also focused closely on the experience with the Greek sovereign debt markets, rather than on the risks of sovereign debt short selling more generally. The European Parliament’s and Council’s extensive and operationally sensitive revisions to the Proposal were not the subject of impact assessment.

Ultimately, however, the law-making process delivered a workable compromise.208 The 2012 Short Selling Regulation does not impose severe constraints on short selling, and the conditions under which NCAs may impose emergency prohibitions are now harmonized, stringent, and subject to ESMA review. The risk of a repeat of the market damage inflicted over the autumn 2008 series of prohibitions should, accordingly, be reduced. The restrictions on uncovered short sales of equity are based in part on tested US practice209 and address the riskiest form of short selling. The contested restrictions on uncovered sovereign debt short sales and related CDS transactions were untested, but they are, at least, calibrated according to the asset class in question and can be suspended in an emergency, albeit subject to stringent conditions.

The administrative rulebook has also provided a corrective mechanism. It has delivered much-needed nuance, draws on empirical evidence and market practice to a greater extent than the 2012 Regulation, and reflects, within the legislative restrictions imposed by the Regulation, market risk-management practices. Similarly, ESMA’s supervisory convergence (p. 549) activities, including its adoption of guidelines in this area, provide a channel through which opacities and ambiguities can be temporarily corrected and market developments reflected.

The regime has also benefited from an early review. The Commission was to report to the European Parliament and Council on the Regulation’s main features210 by end June 2013 (Article 45).211 As discussed in section 3.13, and allowing for the limitations of a review which took place with less than six months’ experience with the measure, it appears that the 2012 Regulation has not generated significant problems, and that market dynamics do not appear to have been prejudicially disrupted. ESMA’s extensive report also underlines both the important corrective function which a review clause can deliver and ESMA’s capacity to engage in ex-post quantitative assessment.

VI.3.4  Harmonization and ESMA

While highly detailed in places, the 2012 Regulation generally operates at a relatively high level of generality. It articulates the hard-fought political compromise on the extent to which short sales of shares and sovereign debt, and transactions in sovereign CDSs, should be restricted. But this compromise was based in part on further calibration and amplification of the regime through extensive administrative rules which would finesse the regime and address the practical implications for risk management and for market liquidity and efficiency. The development of the administrative regime was, accordingly, not only a means for clarifying the regime and addressing matters of great technical detail, but also a critically important process for ensuring that the Regulation, within the parameters set by the political compromise, did not disrupt long-established hedging and risk-management practices.

The sensitivity of the administrative rulebook is reflected in the respective allocation of rules to the traditional Commission-led process for administrative rule adoption, and to the new ESMA-initiated RTS/ITS process for adopting such rules. The most operationally sensitive rules, and those which had the greatest potential to disrupt the political compromise on the legislative text, were adopted through the 2012 Commission Delegated Regulation 918/2012, which was adopted as an administrative measure by the Commission212 following receipt of ESMA’s technical advice213 and a detailed impact assessment by the Commission.214 The Regulation addresses highly sensitive operational issues, including in relation (p. 550) to the type of hedging which renders a sovereign CDS ‘covered’ and so permitted under the foundation 2012 Short Selling Regulation, the notification thresholds for sovereign debt, the market liquidity thresholds at which the prohibition on uncovered sovereign debt short sales can be suspended, when a ‘significant fall in prices’ has occurred such that NCAs can temporarily restrict short sales, and the nature of the ‘adverse circumstances’ which trigger the related emergency powers which can be exercised by ESMA and the NCAs. The two Regulations adopted as RTSs (2012 Commission Delegated Regulations 826/2012 and 919/2012), which were proposed by, and thus driven by, ESMA, albeit adopted by the Commission, address less operationally sensitive issues and are in the main concerned with calculation methodologies and reporting contents and formats. The ITS Regulation (Commission Implementing Regulation 827/2012), which might have been expected to have little impact as a quasi-regulatory measure given the technical and implementation-focused nature of ITSs,215 is of great operational importance, however, in that it sets out the types of arrangement which qualify under the ‘locate’ rule, which is used by the 2012 Short Selling Regulation as a key device for assessing whether or not a short sale of shares or sovereign debt is covered.

Despite the acute time pressure under which it was produced,216 the administrative rulebook has a number of strengths. It reflects a generally good working relationship between the Commission and ESMA and the Commission’s willingness to rely on ESMA’s technical expertise,217 a concern to avoid overly burdensome rules,218 and the significant technical capacity which ESMA has brought to EU law-making. It suffers, however, from the absence of robust empirical data, as was acknowledged by the Commission and ESMA.219 Nonetheless, Commission Delegated Regulation 918/2012, in particular, was subject to extensive market assessment and empirical review and drew, to the extent it was available, on market intelligence and experience.220

(p. 551) ESMA’s supervisory convergence activities provide an additional means for ensuring that the regime does not disrupt efficient market practices and that its myriad complexities are clear. In September 2012, ESMA adopted an extensive ‘Q&A’ document which is regularly updated;221 it provides a dynamic and responsive method for clarifying the regime and for driving consistent implementation.222 ESMA has also shown some enthusiasm for adopting 2010 ESMA Regulation Article 16 guidelines (in relation to which NCAs are subject to a ‘comply or explain’ obligation).223 Shortly after the application of the 2012 Short Selling Regulation, ESMA adopted important guidelines on the operationally significant market-making exemption. The Guidelines, which are, as noted in section 3.5.2 of this Chapter, notable for their robust tone and highly technical quality,224 are designed to provide clarity and support a level playing field with respect to a centrally important exemption.225 But while they underline ESMA’s ability to identify and respond to potential weaknesses in the formal rulebook, they have proved problematic as a convergence tool. Similarly, the 2013 Review of the short selling regime highlights ESMA’s capacity to engage in quantitative analysis of the regime and to influence its future shape.

VI.3.5  Setting the Perimeter: Scope and Exemptions

VI.3.5.1  Scope

The scope of the 2012 Short Selling Regulation is very widely drawn; the perimeter is set by the wide range of instruments subject to the Regulation, not by the market participants who, by holding positions in these instruments, become indirectly subject to the Regulation.226 Accordingly, it has wide extraterritorial reach beyond the EU,227 where short selling activities relate to in-scope instruments.228

Under Article 1, the Regulation applies to three sets of instruments. First, it applies to 2014 MiFID II/MiFIR financial instruments (as defined by Article 2(1)(a)) (Chapter IV section 4.3), where those instruments are admitted to trading on a ‘trading venue’—a regulated market or MTF (as defined by Article 2(1)(l)) in the EU;229 these instruments are in scope when traded outside these venues, as long as they are admitted to these venues (Article 1(1)(a)). (p. 552) Second, it applies to financial, commodity, and other derivatives,230 where those derivatives relate to an Article 1(1)(a) instrument, or relate to an issuer of such an instrument, including when these instruments are traded outside a trading venue (Article 1(1)(b)). Finally, it applies to debt instruments issued by a Member State or the EU, and to Article 1(1)(b) derivatives that relate to or are referenced to debt instruments issued by a Member State or the EU (Article 1(1)(c)). The range of emergency powers which are conferred on NCAs and on ESMA in exceptional market conditions (section 3.9) apply to financial instruments generally, regardless of where they are admitted to trading (Article 1(2)).231

While wide in reach, the regime is significantly calibrated (see also section 3.6). It does not, save in exceptional circumstances, apply to financial instruments generally. Its provisions are generally directed to short sales232 of shares and of sovereign debt,233 and to sovereign CDSs.234 Two sets of obligations apply to these instruments: a trading rule which prohibits uncovered short sales of shares and sovereign debt and transactions in uncovered sovereign CDSs; and a reporting rule in relation to net short positions. In neither case is the domicile or establishment of the person entering into the relevant transaction relevant; the scope of the obligation is dictated by whether the related instruments are within the scope of the 2012 Short Selling Regulation.235

VI.3.5.2  Exemptions

Two exemptions apply to the 2012 Short Selling Regulation.

The first is efficiency-driven and curtails the extraterritorial reach of the Regulation. The disclosure and notification obligations relating to net short positions in shares, the prohibition on uncovered short sales of shares, and the requirements for buy-in procedures in relation to the settlement of shares do not apply to shares of a company admitted to trading (p. 553) on a trading venue in the EU where the ‘principal venue’ (the venue for the trading of that share with the highest turnover) for the trading of the shares is located in a third country (Article 16(1)). The determination as to whether the principal trading venue for a share is outside the EU is the responsibility of the relevant NCA for the shares,236 and is carried out on a two-yearly basis in accordance with the delegated rules which govern the calculation.237 A list of exempted shares is maintained by ESMA.

The second exemption exempts market-making and related activities from the reach of the 2012 Short Selling Regulation (Article 17) in order to ensure that market liquidity, and the related ability of market-makers to take short positions, is not prejudiced. The broadest exemption applies to transactions performed due to ‘market-making activities’ which are exempted from the reporting and public disclosure obligations relating to net short positions, and from the prohibition on uncovered transactions (Article 17(1)). To benefit from the exemption, the market-maker must (under Article 2(1)(k)) come within the classes of market-maker identified in the Regulation (which include, given the reach of the Regulation, third country actors);238 be a member of an in-scope trading venue or an equivalent third country market239 where the actor deals as principal in a financial instrument (whether traded on or outside a trading venue); and act in any one of three capacities.240 The exemption applies only in relation to market-making activities and does not cover proprietary dealing by the actor in question.241 With specific reference to sovereign debt, authorized primary dealers242 are exempted from reporting in relation to net short positions, and from the prohibition on uncovered short sales of sovereign debt and on uncovered sovereign CDSs (Article 17(2)). Notification requirements apply to the relevant home NCA,243 which is empowered to prohibit reliance on an exemption where it considers the related conditions are not met (Article 17(5)–(8)). The NCA may also (p. 554) request information relating to short positions held or activities conducted under the exemption (Article 17(11)).

The market-making exemption has not been the subject of administrative rules but ESMA has adopted detailed related Guidelines, reflecting significant market uncertainty as to the scope of this operationally critical exemption.244 Adopted under ESMA Regulation Article 16, the Guidelines are of a harder quality than the ESMA Short Selling ‘Q&A’: NCAs and financial market participants must make every effort to comply with the Guidelines. NCAs are also required to notify ESMA on whether they have complied with the Guidelines (with reasons for non-compliance); financial market participants are not required to so report.245 While the Guidelines cover, as might be expected, the format and content of the exemption notification in detail, they are notable for the extent to which they tackle the many operational complexities which the exemption has generated,246 and for their detailed coverage of the conduct of market-making activities.247 The scope of the Guidelines has, however, been controversial. Five NCAs, including the NCAs of the largest financial markets in the EU (the markets of the UK, France, and Germany) recorded their non-compliance.248 While their reasons varied, there was strong NCA disagreement with the scope limitations which the Guidelines imposed with respect to trading venue membership.249 As discussed in Chapter X section 5.6, the resilience and authority of ESMA guidelines which the NCAs of the largest financial markets in the EU do not support is questionable.

VI.3.6  Calibration and Differentiation

Calibration and differentiation are recurring themes of the 2012 Short Selling Regulation, which seeks to balance between regulating certain aspects of short selling in the interests of supporting financial stability, particularly in the sovereign debt market, on the one hand, (p. 555) and supporting market liquidity and efficiency and not hindering short sales and related transactions which support liquidity and price formation, on the other.250

While in principle the scope of the Regulation is very wide, in practice the two main sets of rules—the prohibitions on uncovered transactions and the reporting obligations—apply only to shares, sovereign debt, and sovereign CDSs; the inclusion of sovereign bonds and the exclusion of corporate bonds, and the related fragmentation in the regime, underlines the politicization of the negotiations. The regime applies across all financial instruments only in relation to exceptional circumstances and with respect to the related emergency intervention powers of NCAs and ESMA.

The two main sets of rules are further differentiated between the share, sovereign debt, and sovereign CDS asset classes in order to reflect the different dynamics of trading and risk management in these markets, and to reflect the perceived higher risks to liquidity in the sovereign debt markets from the Regulation’s requirements. Generally, exemptions, suspensions of rules, and differentiation between different asset classes are common across the regime.

VI.3.7  Restricting Short Sales: the Uncovered Short Sales Prohibition

VI.3.7.1  The Prohibition

At the core of the 2012 Short Selling Regulation is the prohibition on uncovered short sales of shares and of sovereign debt and on transactions in uncovered sovereign debt CDSs (Articles 4 and 12–13). The conditions which govern whether transactions are ‘covered’ and so outside the prohibition were the subject of intense negotiations, becoming a focal point for the wider debate on the legitimacy and efficacy of short sales, particularly short sales achieved through sovereign debt CDSs. The resulting regime is complex and technical, as it is designed to balance between the need to protect long-standing market hedging and risk-management practices and the need to reflect the strong political concern, particularly in the European Parliament, to prohibit uncovered short sales and uncovered sovereign CDS transactions.

VI.3.7.2  Uncovered Short Sales in Shares

Under Article 12, a natural or legal person may enter into a short sale of a share admitted to trading on a trading venue only where one of three sets of conditions, designed to ensure the sale is ‘covered,’ is met. The conditions have been subject to detailed amplification by 2012 Commission Implementing Regulation 827/2012.

A short sale is covered where the person has borrowed the share or has made alternative provisions resulting in a similar legal effect (Article 12(1)(a)).

A sale is also covered where the person has entered into an agreement to borrow the share or has another ‘absolutely enforceable claim’ under contract or property law to be transferred ownership of a corresponding number of securities of the same class, so that settlement can (p. 556) be effected when it is due (Article 12(1)(b)). The Implementing Regulation specifies the range of agreements and claims which can be employed (futures and swaps; options; repurchase agreements; standing agreements and rolling facilities; agreements relating to subscription rights; and other claims or agreements) and the conditions which these agreements must meet (Article 5).

Finally, and significantly in terms of market practice, a sale is covered where the (highly contested)251 ‘locate rule’ is met, in that the person has an arrangement with a third party under which that third party has confirmed that the share has been located, and has additionally taken ‘measures’ vis-à-vis third parties necessary for the person to have a ‘reasonable expectation’ that settlement can be effected when it is due (Article 12(1)(c)). This ‘locate rule’ and the related ‘measures’ were the subject of intense negotiations at legislative and administrative levels. The 2012 Implementing Regulation sets out the three permissible forms of locate arrangements and measures, and the related confirmations required (Article 6).252 The standard requirement is that the third party (i) confirms, prior to the short sale being entered into by the person, that it considers it can make the shares available for settlement in due time, taking into account the amount of the possible sale and market conditions, and indicates the period for which the share is located, and (ii) confirms, prior to the short sale being entered into, that it ‘has at least put on hold’ the requested number of shares for the person (Article 6(2)). Reflecting the terms of the legislative delegation,253 distinct and lighter requirements apply in relation to confirmations relating to intra-day short sales (Article 6(3)) and short sales of liquid shares (Article 6(4)), both of which qualify the short sale as a covered short sale.254 The 2012 Implementing Regulation also specifies the third party with whom these arrangements can be made (Article 8); in effect, the third party must be a legally separate entity from the short seller.255

VI.3.7.3  Uncovered Short Sales in Sovereign Debt

Similar rules govern whether a short sale in sovereign debt is covered, and so permitted, although an exemption regime applies which reflects significant Member State concern as to the potential damage to the sovereign debt market.

(p. 557) Under Article 13 of the 2012 Short Selling Regulation, a short sale of sovereign debt may only be carried out where the sale is covered, in that it meets one of three conditions. First, the relevant person must have borrowed the sovereign debt or have made alternative provisions resulting in a similar legal effect (Article 13(1)(a)). Second, the person must have entered into an agreement to borrow the sovereign debt or have another absolutely enforceable claim under contract or property law to be transferred ownership of a corresponding number of securities of the same class so that settlement can be effected when it is due (Article 13(1)(b)). Finally, a ‘locate rule’ applies, in that the sale is covered where the person has an arrangement with a third party under which the third party has confirmed that the sovereign debt has been located or (by contrast with the more restrictive confirmation regime which applies to shares), alternatively, otherwise has a reasonable expectation that settlement can be effected when it is due (Article 13(1)(c)).

The restrictions on uncovered short sales of sovereign debt are lighter than those which apply to shares, in order to reflect concern as to the potential detriment to Member States’ management of their budget deficits.256 The 2012 Implementing Regulation 827/2012 accordingly seeks to preserve liquidity in the sovereign debt and related repurchase markets,257 and sets out the types of arrangements and confirmations necessary to provide a reasonable expectation that settlement can be effected when it is due; these requirements are lighter than those which govern share short sales and the related ‘measures’ to be taken (Article 7).258

The political sensitivities associated with restrictions on the sovereign debt markets are also reflected in the lifting of the requirement for a sovereign debt sale to be covered where the sale hedges a long position in debt instruments of an issuer, the pricing of which has a high correlation with the pricing of the sovereign debt (2012 Short Selling Regulation Article 13(2)).259

Additionally, the requirement for short sales to be covered can be temporarily suspended by the relevant NCA260 where it determines that liquidity has become restricted, in that it has fallen below the threshold set by the 2012 Short Selling Regulation (Article 13(3) and (4)). This exemption is designed to address any potential detriment to the liquidity of sovereign debt markets and any potential prejudice to the ability of Member States to finance public deficits which may arise from the prohibition on uncovered short sales, and to allow NCAs to support liquidity in stressed market conditions. Given the sensitivity of this suspension (p. 558) and the related liquidity calculation, the calculation method has been specified in some detail through administrative rules which are designed to ensure that the suspension only applies where there has been a significant decline relative to the average level of liquidity for the sovereign debt, and that the liquidity threshold is based on objective criteria specific to the relevant sovereign debt market.261 The 2012 Commission Delegated Regulation 918/2012 sets out the liquidity threshold calculation method, which is linked to turnover, and which is designed to allow NCAs to take pre-emptive action before sovereign debt liquidity problems arise;262 a temporary suspension may take place where the turnover of a month falls below the fifth percentile of the monthly volume traded in the previous 12 months.263 The relevant NCA must also notify other NCAs and notify ESMA (which is to issue an opinion within 24 hours on the proposed suspension and its compliance with the related conditions). ESMA is accordingly required to opine, in a likely charged and time-pressured environment, on the validity of potentially highly controversial decisions by NCAs. On the one hand, the opinion obligation suggests a possible endorsement from ESMA which could protect the NCA. On the other, the mechanism is double-edged in that where the NCA proceeds despite an unfavourable ESMA opinion, the political and market volatility risks would be considerable.264 The insertion nonetheless of ESMA into the process underlines the political sensitivities associated with restricting uncovered short sales and with loosening those restrictions. The suspension is valid for an initial period not exceeding six months, although it may be renewed for an additional six-month period if the qualifying liquidity conditions continue to prevail.

VI.3.7.4  Uncovered Sovereign CDSs

Most controversy attended the prohibition on uncovered sovereign CDSs; accordingly, a complex regime applies governing when a sovereign CDS is ‘covered’, which is designed to protect legitimate hedging activities. Under the 2012 Short Selling Regulation Article 14(1), a natural or legal person may only engage in a sovereign debt CDS transaction where the transaction does not lead to an uncovered sovereign CDS position. Whether or not a sovereign debt CDS is uncovered and so prohibited is a function of whether it is deployed for the hedging purposes which the 2012 Short Selling Regulation permits.

Two forms of hedging are permitted: hedging against the risk of default of the sovereign issuer, where the person in question has a long position in the debt of the issuer to which the CDS relates; and hedging against the risk of decline of the value of the sovereign debt, where the person holds assets or is subject to liabilities, including but not limited to (p. 559) financial contracts, a portfolio of assets, or financial obligations, the value of which is correlated to the value of the sovereign debt (Article 4). The second of these two hedges—the ‘proxy hedge’—is of central importance to hedging and risk management in the CDS market. The boundary between legitimate and illegitimate proxy hedges is, however, a difficult one to establish and police, given the complexities related to, for example, the extent to which the exposures should be correlated with the CDS,265 as well as the dynamism of the exposures, which can change in value over time, affecting the coverage of the hedge. Accordingly, a highly contested and complex regime, designed to ensure consistency in supervisory and market practice, governs the extent to which the CDS is correlated to the proxy hedged assets or liabilities under the 2012 Commission Delegated Regulation 918/2012 (Articles 14–20).

In essence, under the 2012 Commission Delegated Regulation 918/2012, four major conditions govern whether the sovereign CDS is covered, in that it relates to a legitimate proxy hedge under the short selling regime. First, the assets or liabilities must, reflecting the legislative regime (2012 Short Selling Regulation Article 4) be in the sovereign Member State; despite significant market opposition, cross-border proxy hedges are not permitted save to a very limited extent and in relation to cross-border group-related assets and liabilities (Article 15). Second, the hedged assets and liabilities must come within the scope of the identified assets and liabilities (Article 17). Third, a proportionality requirement applies in that the CDS position must be proportionate to the size of the exposures hedged—although a ‘perfect hedge’ is not required, given the potential volatility of the exposures hedged and the difficulties in exactly capturing the risks in question, and limited over-provisioning is permitted (Article 19). Finally, the nature of the correlation assessment used to ensure the exposures are correlated to the CDS is specified; a quantitative or qualitative assessment may be used (Article 18).266 Under the quantitative element, there must be a correlation coefficient of at least 70 per cent between the price of the assets or liabilities hedged and the price of the sovereign debt;267 the 70 per cent correlation requirement is deemed to be met in specified circumstances, which provide a safe harbour.268 Under the qualitative element, a ‘meaningful correlation’ (which is based on appropriate data and is not evidence of a merely temporary dependence) must be shown.269 A person entering into a sovereign debt CDS position must, on the request of the NCA, demonstrate compliance with the applicable conditions (Article 16).

(p. 560) As with the prohibition on uncovered sovereign debt short sales, the prohibition on uncovered sovereign debt CDSs may be suspended in exceptional circumstances, which are designed to capture situations in which the Member States’ ability to raise funds might be compromised (2012 Short Selling Regulation Article 14(2)). An NCA may suspend the prohibition270 where it has objective evidence for believing that its sovereign debt market is not functioning properly and that the prohibition might have a negative impact on the sovereign CDS market, especially by increasing the cost of borrowing for sovereign issuers or by affecting sovereign issuers’ ability to issue new debt. Any such decision by the NCA must be based on specified indicators relating to: a high or rising interest rate on the sovereign debt; a widening of interest rate spreads on the sovereign debt compared to the sovereign debt of other issuers; a widening of the sovereign CDS spreads as compared to the sovereign debt’s own curve and compared to other sovereign issuers; the timeliness of the return of the price of the sovereign debt to its original equilibrium after a large trade; and the amount of sovereign debt that can be traded.271 As with the suspension regime for uncovered sovereign debt short sales, ESMA must be informed and provide an opinion within 24 hours and other NCAs must be informed. The suspension applies for an initial 12-month period but can be extended subsequently for six-month periods. Additionally, where a suspension applies, natural or legal persons holding an uncovered position in a sovereign CDS must notify the relevant NCA272 where the position reaches or falls below the reporting thresholds for sovereign debt (section 3.8) (2012 Short Selling Regulation Article 8).

VI.3.7.5  Buy-in Procedures

Related procedures apply in relation to the settlement of shares,273 designed to address the settlement risks associated with uncovered short sales and to establish basic standards related to settlement discipline.274 A central clearing counterparty (CCP) in a Member State that provides clearing services for shares must ensure that ‘buy-in’ procedures are in place in accordance with 2012 Short Selling Regulation Article 15. Accordingly, where a natural or legal person who sells shares is not able to deliver the shares for settlement within four business days after the day on which settlement is due, procedures must be automatically triggered for the buy-in of the shares to ensure delivery for settlement. Where the buy-in of the shares for delivery is not possible, an amount must be paid to the buyer based on the value of the shares to be delivered at the delivery date, plus an amount for losses incurred by the buyer as a result of the settlement failure. In each case, the person who failed to settle must provide reimbursement of all amounts paid under Article 15. The CCP must also ensure that procedures are in place to ensure that where a person who sells shares fails to deliver the shares for settlement by the date on which settlement is due, that person must make daily payments (which must be sufficiently high to act as a deterrent) for each day that the failure continues.

(p. 561) VI.3.8  Transparency of Net Short Positions

The restrictions on uncovered short sales are accompanied by disclosure and reporting obligations relating to net short positions. These obligations are designed to enhance NCAs’ ability to monitor short selling activities for potential systemic risk or abusive conduct, and to enhance pricing mechanisms by providing disclosure to the market on short positions. Disclosure requirements in relation to short selling typically take two forms: ‘flagging’ rules, which require that short sale orders are ‘marked’ as the order is placed and that aggregate daily reports based on the marking of orders are filed with the regulator; and requirements governing reporting by individual investors of significant short positions held by them. Although the Commission and European Parliament initially supported the adoption of a flagging regime, the 2012 Short Selling Regulation is based on individual reporting requirements,275 reflecting in part the greater operational experience with this approach by NCAs,276 as well as the data quality risks and limitations of the flagging approach.277

By contrast with the restrictions under the 2012 Short Selling Regulation on uncovered short transactions, the reporting measures benefited from some degree of market and NCA experience. Reporting requirements featured heavily in the autumn 2008 actions taken by NCAs, while CESR’s 2010 Pan-EU Model for Disclosure provided an opportunity for consultation and for analysis of experience to date with position reporting, albeit only with respect to shares. Accordingly, the reporting regime was significantly less controversial during the negotiations.

In the case of shares, a net short position (subject to the reporting obligation) is the position remaining after deducting the long position held in relation to the issued share capital278 from any short position held in relation to the share capital (Article 3(4)). An expansive approach has been adopted to the net short position assessment, which is designed to capture the building of positions through derivatives: a short position in shares is one which results from either a short sale of a share issued by a company or (engaging derivative use) from a transaction which creates or relates to a financial instrument other than a share, where the effect (or one of the effects) of the transaction is to confer a financial advantage on the person entering into the transaction in the event of a decrease in the price or value of the share (Article 3(1)). A long position, conversely, arises from holding a share, or from a transaction which confers an advantage in the event of an increase in the price or value of the share (Article 3(2)). Where a position is held indirectly (including through an index, a basket of securities, or an exchange-traded fund (ETF)), the person in question must (p. 562) determine whether the reporting requirement applies, acting reasonably having regard to publicly available information as to the composition of the relevant index or other vehicle.279 The administrative regime amplifies when a person ‘holds’ a share280 and provides further detail on how the calculation of net short positions is carried out (with particular reference to the range of derivatives which can be used to build a position),281 including with respect to when different entities in a group have long or short positions282 and in the context of fund management activities.283

In the case of sovereign debt, a net short position is the position remaining after deducting any long position held in the issued sovereign debt,284 and also after deducting any long position in debt instruments of a sovereign issuer, the pricing of which is ‘highly correlated’285 to the pricing of the given sovereign debt, from any short position held in relation to the same sovereign debt (Article 3(5)). The calculation of long and short positions in sovereign debt is to be made for each single, sovereign issuer, even if separate entities issue debt on behalf of the sovereign issuer, and sovereign CDSs referenced to the sovereign issuer must be included in the calculation286 (Article 3(3) and (6)); otherwise the calculation is as for shares (Article 3(1) and (2)).287

For net short positions in shares, two reporting thresholds apply: in relation to NCA reporting and in relation to public reporting. A person who has a net short position in relation to the issued share capital of a company that has shares admitted to trading on a trading venue must notify the relevant NCA288 where the position reaches or falls below 0.2 per cent of the (p. 563) issuer’s share capital initially,289 and each 0.1 per cent above that (Article 5). Public disclosure of net short positions is required at a higher level,290 where the position reaches or falls below the higher threshold of 0.5 per cent of the issued share capital, and each 0.1 per cent above that (Article 6291).292

Article 7 governs reporting on net short positions relating to sovereign debt,293 which is required of NCAs only. Given the complexities,294 the relevant thresholds were not set in the Short Selling Regulation, but were specified in the 2012 Commission Delegated Regulation 918/2012 (Article 21). Sovereign debt is classified into three baskets for the purposes of determining which reporting threshold applies.295 An initial 0.1 per cent (of the total amount of outstanding sovereign debt, regardless of different issues) and a subsequent 0.05 per cent threshold applies where the total amount of outstanding issued sovereign debt is between 0 and 500 billion euro. Where the outstanding debt is above 500 billion euro, or where there is a liquid futures market for the particular sovereign debt, an initial 0.5 per cent and subsequent 0.25 per cent threshold applies. In practice, the reporting threshold is fixed at particular monetary amounts. In accordance with 2012 Short Selling Regulation Article 7(2) and 2012 Commission Delegated Regulation 918/2012, ESMA has placed Member States’ sovereign debt in one of these three baskets (0–500 billion euro, 500 billion +, and liquid futures market) and has published the particular monetary amounts, in relation to Member States’ sovereign debt, to which the reporting obligation attaches.296 Public disclosure is not required given the potential for damage to liquidity, particularly in markets which are under liquidity pressure.

(p. 564) The method of NCA notification (and of public disclosure as relevant) is governed by the 2012 Short Selling Regulation (Article 9) and the related administrative rules. Under Article 9(1), the notification or disclosure must set out details of the identity of the person, the size of the relevant position, the issuer in question, and the date on which the position was created, changed, or ceased to be held. Public disclosures must be made in a manner which ensures fast access to the information on a non-discriminatory basis and the information must be posted on a website operated or supervised by the relevant NCA; ESMA also hosts links to these websites (Article 9(4)). Article 9 also addresses the relevant time at which the calculation must be made and the confidentiality of disclosures provided to the NCA. The administrative regime specifies further the content of NCA notifications,297 the means through which public disclosure can be made in relation to shares, and the format in which NCA reports are to be made.298

The reporting regime is cascaded to ESMA, which acts as a central repository for reporting on net short positions. NCAs must provide information in summary form to ESMA on a quarterly basis on net short positions relating to shares and sovereign debt (and uncovered sovereign CDS as relevant) (Article 11(1)). ESMA may also request, at any time and in order to carry out its duties under the Regulation, additional information from NCAs on net short positions related to shares, sovereign debt, or uncovered sovereign CDSs (Article 11(2)). The format and content of these reports has been specified by the administrative regime.299

VI.3.9  Intervention in Exceptional Circumstances

VI.3.9.1  NCA Powers

The prohibitions on uncovered short transactions and disclosure/notification requirements are at the core of the 2012 Short Selling Regulation, but apply to specific instruments only. While, as discussed in this section, a series of more wide-ranging intervention powers are conferred on NCAs and on ESMA, they apply in exceptional or emergency conditions. Disorderly market conditions are also addressed by the 2014 MiFID II/MiFIR, which confers new powers in relation to position management (sections 2.5 and 2.6).

The additional and exceptional NCA intervention powers are triggered when there are adverse events or developments which constitute a serious threat to financial stability or to market confidence in the Member State concerned or in one or more other Member States300 and the measure in question is necessary to address the threat and will not have a (p. 565) detrimental effect on the efficiency of financial markets which is disproportionate to its benefits; the NCA’s determination in this respect is reviewed by ESMA. Where these threshold conditions are met, the NCA may require persons who have net short positions in relation to a specific financial instrument or class of financial instruments to notify to it, or to disclose to the public, details of the position where the position reaches or falls below a threshold fixed by the NCA (Article 18); the NCA may provide for exceptions, including in relation to market-making and primary market activities.301 The NCA may also require persons engaged in the lending of a specific financial instrument or class of financial instrument to notify any significant change in the fees requested for such lending (Article 19). More interventionist action is envisaged by Article 20, which empowers the NCA to prohibit or impose conditions relating to persons entering into a short sale or a transaction other than a short sale which creates, or relates to, a financial instrument, and the effect (or one of the effects) of that transaction is to confer a financial advantage on the person in the event of a decrease in the price or value of another financial instrument.302 Similarly, Article 21 empowers the NCA to restrict the ability of persons to enter into sovereign CDS transactions or to limit the value of sovereign CDS transactions.303

A specific ‘circuit-breaker’ power, which is not subject to the Article 18–21 threshold/qualifying conditions, applies in relation to the temporary restriction of short sales in financial instruments in the case of a ‘significant’ fall in price (Article 23), and is designed to prevent disorderly declines in the value of particular financial instruments.304 Where the price of a financial instrument on a trading venue has ‘fallen significantly’ during a single trading day (in relation to the closing price on the venue on the previous trading day), the NCA of the home Member State for that venue must consider whether it is appropriate to prohibit or restrict persons from engaging in short selling of the financial instrument on the trading venue, or otherwise to limit transactions in that financial instrument on that trading venue, in order to prevent a disorderly decline in the price of the financial instrument. Where the NCA is satisfied that it is appropriate to do so, it must, in the case of a share or debt instrument, prohibit or restrict persons from entering into a short sale on that trading venue or, in the case of another type of financial instrument, limit transactions in that financial instrument on that trading venue in order to prevent a disorderly decline in the price of the financial instrument.305 The extent of the falls in value which trigger this power are specified by the 2012 Short Selling Regulation and its supporting administrative rules. The Regulation provides that a fall in value of 10 per cent amounts to a significant fall in (p. 566) value for a liquid share. The required fall in value for illiquid shares and other financial instruments is governed by 2012 Commission Delegated Regulation 918/2012.306 The thresholds are set at levels designed to ensure that NCAs are not required to repeatedly and unnecessarily consider whether Article 23 ‘circuit-breaker’ action should be taken.307

The Article 18–21 intervention powers can only be triggered when the threshold conditions are met. The Article 23 powers are also confined in that the required ‘significant fall’ has been specified in some detail. Procedural requirements also apply to these exceptional powers. The Article 18–21 restrictions may only be valid for an initial period of three months, which may be extended by further three-month periods (Article 24); short time limits also apply to the Article 23 power.308 Any exercise of power under Articles 18–21 and 23 must also be disclosed on the NCA’s website and notified to the other NCAs (Article 26).309

Any proposed use of the Article 18–21 and 23 powers (and any renewal of related decisions) must be notified to ESMA (Article 26).310 ESMA must also issue a publicly disclosed opinion on whether it considers the proposed Articles 18–21 measure necessary to address the applicable exceptional circumstances311 (Article 27(2)).312 ESMA’s approach thus far has been supportive, although its opinions have been somewhat economically reasoned, as might be expected given the sensitivities of short selling restrictions.313 An NCA can choose (p. 567) to take action contrary to the ESMA opinion, but must publicly explain its reasons for doing so; ESMA may also consider whether exercise of its exceptional Article 28 intervention powers (discussed later in this section) is then warranted.

ESMA is less engaged with the Article 23 ‘circuit-breaker’ power, reflecting its time-sensitive nature. ESMA must, however, be notified and is required to co-ordinate where the instrument in question is traded in a number of venues across the Member States. The NCAs of those other venues must be notified by ESMA and where disagreement arises between the NCAs concerned, ESMA must mediate between the NCAs, failing which ESMA can impose a decision in relation to the treatment of the instrument concerned.314

VI.3.9.2  ESMA Powers

The political decision to confer direct operational powers on ESMA in relation to short selling was taken prior to the adoption of the 2012 Short Selling Regulation and during the negotiations on the foundation Regulations for the European Supervisory Authorities (ESAs). At the instigation of the European Parliament, an enabling clause was added to the ESAs’ founding Regulations which permits the ESAs to prohibit or restrict financial products or services, once the specific power is conferred in the relevant legislation.315 A specific power to this effect has been conferred under the 2012 Short Selling Regulation, which has the effect of empowering ESMA in a highly sensitive area.

ESMA enjoys a range of powers, however, in relation to short selling, which span the spectrum of intervention from facilitation of Member State action to direct action by ESMA. Under Article 27, ESMA is to perform a co-ordination and facilitation role in relation to emergency (Articles 18–21 and 23) measures taken by NCAs and is to ensure a consistent approach is taken by NCAs. As noted above, ESMA is required to provide an opinion on Article 18–21 action and can facilitate mediation in the case of disputes between NCAs in relation to Article 23 action. ESMA is also empowered to conduct an inquiry (on its own initiative, or at the request of the Council, the Commission, the European Parliament, or one or more NCAs) into a particular issue or practice relating to short selling or into the use of CDSs, in order to assess whether potential threats to financial stability or market confidence in the EU are engaged (Article 31). ESMA is also centrally involved in the adoption of co-operation agreements between NCAs and third countries in relation to information exchange and the enforcement of the 2012 Short Selling Regulation in third countries (Article 38; see section 3.11).

In a precedent-setting extension of ESMA’s powers, it is also empowered, subject to strict conditionality, to take direct action with respect to short selling (Article 28). Where the relevant threshold conditions are met, ESMA must either: require persons who have net short positions in relation to a specific financial instrument or class of financial instrument to notify an NCA or to disclose to the public details of any such position; or prohibit or impose conditions on the entry by the person into a short sale or a transaction which (p. 568) creates, or relates to, a financial instrument (other than sovereign debt or derivatives related to sovereign debt, including CDSs) where the effect (or one of the effects) of the transaction is to confer a financial advantage on such person in the event of a decrease in the price or value of another financial instrument (Article 28(1)).316 These measures, which are valid for three months in the first instance,317 prevail over any previous measure taken by an NCA under Articles 18–21 and 23 (Article 28(11)). Before ESMA can act, stringent threshold conditions must be met. The measures must address a threat to the orderly functioning and stability of financial markets or to the stability of the whole of part of the financial system in the EU, and there must be cross-border implications.318 It must also be the case that no NCA has taken measures to address the threat, or that one or more NCAs have taken measures that do not adequately address the threat (Article 28(2)). In addition, before taking action, ESMA must take into account the extent to which the measure: significantly addresses the threat to the orderly functioning and integrity of financial markets or to the stability of the whole of part of the financial system in the EU, or significantly improves the ability of NCAs to monitor the threat; does not create a risk of regulatory arbitrage; and does not have a detrimental effect on the efficiency of financial markets, including by reducing liquidity in those markets or creating uncertainty for market participants that is disproportionate to the benefits of the measure (Article 28(3)). A number of procedural notification requirements must also be met. The European Systemic Risk Board (ESRB) and, where relevant, ‘other relevant authorities’319 must be consulted before ESMA acts (or decides to renew a measure) (Article 28(4)). The NCAs concerned320 must also be notified at least 24 hours in advance of ESMA action,321 and public disclosure made322 in relation to any Article 28 decision or a renewal of a decision (Article 28(5)–(9)).

While sovereign debt is expressly excluded from the Article 28 power, a somewhat otiose but politically driven declaratory provision states that in the case of an emergency situation as defined in the foundation ESMA Regulation, ESMA’s related emergency powers323 apply (Article 29).

As is implicit in the tight conditions which govern action by ESMA, and by the exclusion of sovereign debt—and although this power was foreseen by the 2010 ESMA Regulation—(p. 569) ESMA’s direct powers of intervention were controversial in the negotiations on the 2012 Short Selling Regulation. In particular, while the European Parliament supported powers of intervention for ESMA in the sovereign debt and CDS markets,324 these powers proved highly contentious during Council negotiations, given the potential impact of any such intervention on a Member State’s borrowing costs, and were not supported. Some Member States were also of the view that the short selling powers conferred a wide discretion on ESMA potentially in breach of the Court of Justice’s Meroni ruling, which prohibits any delegation of powers from an EU institution which involves the exercise of wide discretion by the delegate.325 In June 2012 the UK launched a challenge to the Article 28 power based on a series of grounds, chiefly relating to the power’s breach of the conditions which apply to the delegation of powers to ESMA. In January 2014 the Court rejected the challenge, finding that ESMA’s executive discretion was appropriately confined, and underlining the importance of the power in supporting financial stability and the technical capacity which ESMA brought to EU financial system governance.326

It remains to be seen how ESMA will shape operational decisions by NCAs in emergency conditions, and how ambitious it will be in deploying its direct powers. Initial indications suggest a cautious approach, supportive of NCA action, although ESMA has yet to be faced with pan-EU market turbulence of a scale that warrants co-ordinated action by NCAs and potential intervention by ESMA. The legal and political sensitivities associated with direct intervention suggest that, notwithstanding the Court’s 2014 confirmation of the validity of (and necessity for) its powers, ESMA is likely to be particularly cautious before deploying Article 28.

VI.3.10  Supervision and Enforcement

As with other EU securities and markets regulation measures, the 2012 Short Selling Regulation requires that NCAs be designated for the purposes of the Regulation (Article 32) and addresses NCA powers (Article 33) and ESMA/inter-NCA co-operation, including in relation to on-site inspections or investigations (Articles 35–37).327

While the framework for NCA action and co-operation is broadly similar to that which applies across EU securities and markets regulation, a discrete information-gathering power is conferred which empowers NCAs to require a person entering into a CDS transaction (whether a sovereign CDS or otherwise) to provide an explanation for the purpose of the transaction and whether it is for hedging against a risk or otherwise, and to provide information verifying the underlying risk where the transaction is for hedging purposes (Article 33(3)). As discussed in section 3.12 of this Chapter, ESMA’s ability to shape supervisory practices is significant given the scale of its supervisory convergence activities and the direct powers it can deploy.

(p. 570) The enforcement regime is based on the less articulated model which prevailed prior to the enhancement of enforcement in later crisis-era measures.328 Accordingly, Member States must establish rules on penalties and administrative measures which must be effective, proportionate, and dissuasive; they must also provide ESMA on an annual basis with aggregated information on penalties and administrative measures imposed (Article 41). ESMA is empowered to adopt guidelines to ensure a consistent approach to penalties and administrative measures.

VI.3.11  Third Countries

The 2012 Short Selling Regulation has significant extraterritorial effects, as its scope is determined by whether the instrument in question is within the scope of the Regulation.329 The Regulation specifies, for example, that the reporting and disclosure requirements in respect of net short positions apply to persons domiciled or established in the EU or a third country (Article 10), while ESMA has repeatedly underlined that the Regulation’s obligations generally are not dependent on the location of the market participant in question.330

The regime contains few exemptions from its application to third country actors. While admission to an EU-regulated market or trading venue is required to bring some instruments into scope, it is not a condition for all instruments. Shares are, however, exempted from the 2012 Regulation where the principal venue on which they are traded is outside the EU (section 3.5.2). Third country market-makers benefit from the Article 17 market-making exemption, but only where the Commission has made the related equivalence determination in relation to the legal and supervisory framework of the third country in accordance with Article 17.331

The extraterritorial reach, and related exporting effect, of the 2012 Short Selling Regulation is reflected in the obligations imposed on NCAs and on ESMA in relation to third country co-operation arrangements. Under Article 38 NCAs must, where possible, conclude co-operation arrangements with supervisory authorities of third countries concerning the exchange of information.332 Co-operation arrangements must also, and more radically, address the enforcement of obligations arising under the Regulation in third countries, and the taking of intervention measures similar to Articles 18–21, 23, and 28 in third countries. ESMA is charged with co-ordinating the adoption of co-operation arrangements, although the agreements are executed bilaterally between the relevant NCA and third country (p. 571) supervisor. ESMA is, however, centrally engaged with the development of these arrangements, being required to co-ordinate the development of co-operation arrangements and to prepare a template for such arrangements (Article 38(3)). ESMA is also charged with co-ordinating information exchange between NCAs and third country supervisory authorities in relation to emergency intervention measures (Article 38(3)).

VI.3.12  ESMA and the Short Selling Regime

As noted in section 3.4, ESMA has been a material influence on the short selling ‘rulebook’. It can also deploy significant operational powers which contrast sharply with CESR’s comparative impotence in this field. Although short selling came directly within CESR’s sphere of competence and influence, CESR was out-gunned by the Member States and their NCAs in the early stages of the financial crisis in autumn 2008. Although CESR included convergence on short selling in its initial own-initiative agenda on the financial crisis,333 and succeeded in adopting a pan-EU reporting regime (which was ultimately reflected in the Regulation), its ability to co-ordinate in emergency conditions proved limited; it provided only basic co-ordination support to the prohibition of short selling by NCAs in September 2008, although it subsequently established a task force to support co-ordination and consulted with stakeholders on the impact of the restrictions.334

Initially, and prior to the adoption of the 2012 Short Selling Regulation, ESMA proved similarly unable to deliver a co-ordinated approach to short selling, particularly during the August 2011 turmoil, reflecting the intense political interests engaged. Since then, ESMA’s capacity has been significantly strengthened by the Regulation.

ESMA acts as a central hub for reporting and disclosure on net short positions,335 is conferred with co-ordination and facilitation responsibilities, and is empowered to provide opinions on the compliance of NCAs’ emergency actions in relation to short selling and in relation to the politically charged power of NCAs to suspend restrictions on uncovered sovereign debt short sales and uncovered sovereign CDS transactions. ESMA is also charged with co-ordinating the arrangements between third country supervisors and NCAs in relation to information exchange and the enforcement of the regime in third countries. Most radically, it has been conferred with direct operational powers in emergency situations, and can impose reporting requirements and restrictions on short sales of financial instruments in any Member State.

It remains to be seen whether ESMA can drive a co-ordinated pan-EU response to short selling, particularly in emergency conditions. The disorderly responses in autumn 2008, (p. 572) May 2010, and August 2011 underline the acutely sensitive political context within which these restrictions are typically imposed, as well as the distinct local market conditions which drive particular NCA responses. Whether or not the extent to which the legal regime relating to short selling has been harmonized, and the new dynamic which ESMA has brought to supervisory convergence generally, can counteract these strong forces remains to be seen. But some degree of variance in this most sensitive of areas seems unavoidable, as well as appropriate. Overall, however, the short selling regime has provided ESMA with the means to exert its nascent authority on the EU’s financial markets.

VI.3.13  Impact

In June 2013 ESMA issued a report on the 2012 Short Selling Regulation to the Commission, designed to inform the Commission’s required review of the Regulation.336 ESMA’s main findings (in relation to the first five months or so of the Regulation being in force) were broadly positive. Overall, as compared to a control group of US shares, it found a slight decline in the volatility of EU shares, mixed effects on liquidity (a decrease in bid-ask spreads and no significant impact on traded volumes), and a decrease in price discovery effectiveness.337 It found that the thresholds for NCA reporting and public disclosure in relation to shares were appropriate,338 and suggested only minor revisions.339 It recommended, however, that the NCA reporting threshold for sovereign debt be revised, given very limited reporting and reflecting general market unhappiness with the reporting thresholds.340 With respect to the restrictions on uncovered short sales in shares and in sovereign debt, it found a reduction in the incidence of settlement failure, although it also noted that the securities lending market may have been adversely affected by the locate rule in particular.341 While it supported maintaining the restrictions on uncovered short selling, it recommended some adjustments to the regime, particularly with respect to the ‘locate rule’.342 The highly contested prohibition on uncovered sovereign CDSs had not had a ‘compelling impact’ on the liquidity of the EU CDS market or on the related sovereign debt market, although a decline in activity in sovereign CDSs in a few EU Member States and reduced liquidity in EU sovereign CDS indices had occurred. ESMA recommended that the prohibition be kept under review and suggested a number of refinements to the regime to support legal certainty.

(p. 573) The exemption for market-making, however, was found to be problematic in practice, being restrictive in scope and unclear.343 ESMA’s recommendations included that the scope of the exemption be extended to include OTC market-making activities, in order to protect liquidity and avoid higher costs.

Finally, ESMA found that NCA exercise of emergency powers under the Regulation had been necessary and appropriate—although it recommended that the thresholds for Article 23 circuit-breaker intervention be lowered, given evidence that, in certain asset classes, the thresholds were being crossed overly frequently, and that most NCAs did not deem it necessary to impose short sale prohibitions when the threshold was crossed.344

The Commission in response concurred with ESMA’s findings, concluding that, based on the limited evidence available, the Regulation had a positive impact in terms of greater transparency of short sales and reduced settlement failures, albeit that the economic impact was mixed. While it noted ESMA’s proposals for reforms, it decided against taking action, given in particular the limited empirical evidence available, and called for a second review of the Regulation, on the basis of more extensive empirical evidence, by end 2016.345

The review of the Regulation suggests that it has not, at least, been disruptive and, broadly, has had positive effects. It also augurs well for the future development of the regime. ESMA’s analysis was empirically driven346 and cautious,347 as was the Commission in response.

VI.4  Trading in the OTC Derivatives Markets

VI.4.1  The Reform Agenda

The significant expansion in the reach of trading regulation over the OTC markets, and in particular over the OTC derivatives markets,348 is one of the defining features of the G20 reform programme349 and of crisis-era EU securities and markets regulation.

(p. 574) Prior to the financial crisis, the OTC derivatives market350 had expanded exponentially.351 OTC derivatives markets were largely unregulated: trading occurred outside regulated organized venues and often on a bilateral basis between counterparties; transactions were not subject to formal clearing requirements; and risk mitigation and reporting requirements were limited. The financial crisis exposed the very significant transparency and resilience risks which had been building up,352 notably through the massive increase in reliance on credit derivatives, and in particular CDSs, to manage exposures from asset-backed securitization transactions.353 The March 2008 Bear Stearns collapse, the September 2008 default of Lehmans, and the September 2008 bailout of AIG354 triggered widespread market concern as to the extent to which institutions were exposed to CDSs and to the related counterparty risk.

The difficulties in the OTC derivatives market were driven by the opacity of the OTC derivatives market generally355 and of the CDS segment in particular, and the extent to (p. 575) which the market was concentrated356—major institutions, with systemic implications, were closely interlinked through derivatives exposures.357 The extent of the interlinkages between counterparties, and the degree of concentration of exposure risk among counterparties, transformed counterparty risk (which strongly characterizes OTC derivatives transactions, as counterparty risk can persist for several years)358 into systemic risk.359 With respect to opacity risks, the bilateral nature of the market meant that the market was largely opaque; accordingly, the extent to which exposures were concentrated and where they were concentrated was not clear.360 Demands to post higher quality collateral to cover counterparty exposures as the creditworthiness of counterparties in the OTC derivatives market deteriorated added to the intense pro-cyclical pressure in the market as the financial crisis deepened. It also became clear that OTC derivatives contracts were often under-collateralized,361 and that operational risks were significant, particularly in relation to asset segregation. In response, financial institutions, and particularly credit institutions, withdrew credit facilities given the potential extent of counterparty risk, thereby aggravating the credit and liquidity contraction over autumn 2008.

Reform of the OTC derivatives market quickly became a central element of the G20 reform agenda. The April 2009 London G20 meeting committed to promoting the standardization and resilience of credit derivatives markets, in particular through the establishment of CCPs subject to effective regulation and supervision.362 The reform agenda was significantly expanded by the September 2009 Pittsburgh G20 meeting, which made a commitment that all ‘standardized OTC derivative contracts’ would be traded on exchanges or ‘electronic trading platforms’ and cleared through CCPs by the end of 2012. It also agreed that OTC derivative contracts would be reported to trade repositories and that non-centrally cleared contracts would be subject to higher capital requirements.363

(p. 576) The clearing/margin (2012 EMIR), reporting (2012 EMIR), and trading (2014 MiFID II/MiFIR) elements of the G20/EU reform agenda are considered in sections 4.2 and 4.3 of this Chapter. The higher capital requirements for non-centrally cleared contracts have been addressed by the 2013 CRD IV/CRR requirements which implement the Basel III reforms.364 The EU has also pulled OTC trading in derivatives within the regulatory net through a variety of other regulatory mechanisms, including position controls (including under the short selling regime, particularly with respect to sovereign debt CDSs—see section 3—and under the 2014 MiFID II/MiFIR position-management regime for commodity derivatives—see section 2.5); new transparency requirements for the trading venues on which certain classes of OTC derivatives must now be traded (Chapter V); transaction reporting requirements which now capture transactions in a range of OTC derivatives (Chapter V); and the new market abuse regime (Chapter VIII). More generally, the more intensive prudential regulation of investment firms and the imposition of more demanding risk-management requirements (Chapter IV) can also be associated with a policy concern to manage derivative-related risks. Together, the reforms can reasonably be described as having led to a paradigm shift in the intensity with which OTC derivatives markets are regulated.

VI.4.2  2012 EMIR

VI.4.2.1  Introduction: the 2012 EMIR Regime

(a)  2012 EMIR: Main Features

The 2012 EMIR365 is an infrastructure-related measure which brings radical change to the regulation of the OTC derivatives market in the EU. It has two major objectives. First, it is designed to reduce risk and strengthen derivatives market resiliency through, first, a CCP clearing obligation and related CCP risk-management requirements (including in relation to the margin which clearing members provide to CCPs as counterparty risk mitigation366) and, second, risk-management requirements for non-centrally cleared derivatives, which are designed to strengthen the extent and quality of collateralization of non-cleared derivatives transactions. Second, EMIR is designed to support market discipline and regulatory oversight through the imposition of extensive reporting requirements; EMIR and the 2014 MiFID II/MiFIR (Chapter V) together significantly expand the trading disclosures available to the market and to NCAs.

(p. 577) The behemoth EMIR delegated rulebook is composed of 12 regulations, all highly operational in nature. EMIR has, so far,367 been amplified by eight administrative RTSs and four administrative ITSs. Chief among these are the 2013 Commission Delegated Regulation 149/2013, which amplifies EMIR in relation to the pivotal CCP clearing obligation and the risk mitigation requirements for non-cleared OTC derivatives, and the 2013 Commission Delegated Regulation 153/2013, which sets out in detail the organizational, conduct, and prudential requirements for CCPs.368 The administrative regime also includes RTSs on the data to be reported to trade repositories,369 the application data required for trade repository authorization,370 the data to be published by trade repositories,371 the capital requirements for CCPs,372 the colleges of supervisors for CCPs,373 and in relation to the application of EMIR’s clearing obligation to contracts involving third country counterparties.374 Four ITSs govern the format of the different reports and applications required under EMIR.375 The Commission has also adopted administrative rules (not in the form of BTSs) governing the fees charged by ESMA with respect to its supervision of trade repositories, the exemptions available for third country monetary authorities, and the procedures to be followed in relation to ESMA’s power to impose penalties on trade repositories.376

To achieve its objectives, EMIR imposes three major classes of obligation on market participants. First, certain classes of OTC derivatives (or derivatives which are not traded on a regulated market,377 and including interest rate, foreign exchange, credit, equity, and commodity derivatives) must be cleared through CCPs which are authorized under EMIR. Not all OTC derivatives are appropriate for CCP clearing, however;378 non-centrally cleared OTC derivatives are accordingly, second, subject to a range of risk mitigation techniques, including collateral/margin rules. Third, all transactions in financial derivatives within the scope of EMIR (whether cleared or not, and whether traded on a regulated market or not) must be reported to trade repositories.

(p. 578) In support of this regime, extensive organizational, conduct-of-business, and prudential requirements are imposed on the CCPs which are the centre of EMIR’s regulatory design. Trade repositories are also subject to a new regulatory regime.

EMIR has a very wide scope, applying to financial counterparties but also, and controversially, to non-financial counterparties, such as commercial firms which engage in derivative trading incidentally and in order to hedge against risks arising from their commercial and treasury activities. It is accordingly calibrated in order to minimize the costs and any potential prejudice to the efficiency with which firms can engage in risk management.

EMIR has strong market-shaping effects which derive in the main from the pivotal CCP clearing obligation. But EMIR does not intervene more radically in the derivatives market by, for example, taking a position on the optimum number of CCPs.379 The organizational rules designed to support optimum risk management by CCPs, for example, are also designed to protect the CCP market against risks arising from competition in the CCP segment (section 4.2.10). EMIR does, however, seek to ensure that access to CCPs by market participants is not obstructed by discriminatory conditions; it contains a number of non-discrimination provisions designed to ensure that silo-based CCP structures (or structures which vertically integrate trading and clearing services) do not discriminate (section 4.2.6). EMIR also provides regulatory support to, for example, the development of indirect CCP clearing (Article 4(3)) and CCP interoperability (Articles 51–54), both of which services are projected to develop in response to the new clearing environment.

(b)  EMIR and CCP Clearing

The CCP clearing obligation is at the core of EMIR. Clearing in the OTC derivatives markets,380 which evolved as a means for managing counterparty risk, can happen in two ways. The first method, bilateral clearing, involves the two counterparties to the derivative contract entering into a bilateral clearing arrangement which is supported by risk mitigation techniques, including collateralization; this method dominated prior to the crisis. The second method involves central clearing through a CCP.381 In CCP clearing, the CCP interposes itself between the two counterparties to the trade. Accordingly, the derivative contract between the counterparties is split into two offsetting transactions, each of which is supported by the CCP, which becomes the legal counterparty to each trade. CCP clearing supports the stability and resilience of the market in cleared derivatives through, first, ex-ante centralization within the CCP of counterparty credit risk assessment (and the related assessment of margin and collateral requirements), and, second, in the case of a default, ex-post replacement by the CCP of the trades of the failed counterparty and the application of pre-set and orderly procedures (including multilateral netting arrangements) to manage the (p. 579) default and related ‘close-out’ positions (CCP clearing thereby obviates the need for multiple actions by multiple counterparties).382

In order to manage the risk of a default by a CCP clearing member and to ensure it has sufficient resources, the CCP collects margin from the clearing member383 in the form of high-quality collateral384 which is designed to allow the CCP to replace the trades of the member if it defaults; accurate assessment of margin requirements is fundamental to effective risk management by a CCP. The mutualization of risk, in the form of a ‘default fund’ to which all CCP members must contribute and which is available in the event of a member default, also forms a central element of the CCP’s risk-management model. In addition, other CCP financial resources stand behind the default fund if it is depleted on a default. This ‘waterfall’ or hierarchy of resources is designed to ensure the CCP can withstand a major shock to its stability. CCPs also impose a range of risk-management obligations on their members385 and undertake a range of related risk-management functions (including with respect to the valuation of margin and collateral, monitoring the creditworthiness of clearing members, and with respect to supporting orderly default—for example with respect to the segregation and orderly recovery of members’ and their clients’ assets).

(c)  The Risks for the EU

Prior to the financial crisis, only a small portion of the OTC derivatives market was cleared centrally through CCPs,386 and only a limited number of CCPs for OTC derivatives were established in the EU.387 The 2012 EMIR is projected to lead to a massive increase in the (p. 580) volume of derivatives cleared through CCPs.388 While some indications augur well for its success,389 a number of risks follow, chief among them risks related to systemic risk management and to the stability of the CCP market.

The mandatory CCP clearing reform has the effect of concentrating risk to a systemic extent within CCPs.390 The extent to which CCPs can manage and contain systemic risk is in large part a function of their ability to manage the risks associated with the derivatives which they clear; it is accordingly also a function of the scope of the CCP clearing obligation and of the nature of the derivatives which become subject to the CCP clearing obligation. Particularly in the case of highly complex derivatives, bilateral OTC dealers may be better equipped than CCPs to engage in valuation and in risk assessment, and their incentives to engage in strong risk management may be sharper.391 Nonetheless, the OTC derivatives market reform agenda quickly adopted a prescriptive, mandatory CCP clearing approach in order to support global convergence and to ensure the G20 commitment was securely implemented.392 EMIR (reflecting the G20 agenda) recognizes, however, that bilateral clearing of bespoke derivatives remains a centrally important feature of the financial system’s risk-management architecture;393 the EMIR Article 11 risk mitigation standards recognize that segments of the OTC derivatives markets are not appropriate for CCP clearing, and impose functionally equivalent risk-management regulation for bilaterally cleared derivatives. But it remains unclear whether the scope of the CCP clearing obligation has been sufficiently carefully delineated.

In addition, market structure risks, which impinge on systemic stability, arise, particularly as the competition dimension of EMIR (evident in EMIR’s support of interoperability between multiple CCPs—see section 4.2.10) and its financial stability objectives may be in tension. The optimum market structure for the CCP market is not clear. On the one hand, the stability risks which CCPs generate suggest that a monopoly structure, based on a single (p. 581) (or a small number of) CCP(s) clearing a particular asset class may be the safest model; on the other, where a number of competing CCPs clear derivatives, risk may be dispersed across the different CCPs.394

Ultimately, the systemic risks generated by these new and massive ‘risk nodes’ within the financial system are significant and may heighten the likelihood of a tax-payer bailout being needed.395 Efforts to develop a common approach to CCP resolution in the case of default underline the strength of EU policy concern that CCP failure does not become an occasion for a tax-payer bailout, as well as the reality that CCP failure would generate a massive risk to systemic stability.396

The costs of the new regime represent another source of risk. EMIR generates a range of costs, including in relation to CCP membership and related operational changes, but also in relation to the reporting of trades to trade repositories and in relation to the new risk-management rules for bilaterally (non-CCP) cleared derivatives. These costs are predicted to significantly increase the costs of derivatives transactions, particularly for non-financial counterparties who use derivatives for commercial and treasury (funding) hedging purposes. The most significant costs have been associated with the new margin and collateral requirements.397 Demand for high-quality collateral is also likely to intensify in response to EMIR (as well as in response to other reforms and given commercial incentives).398 The margin and collateral costs are not only a function of the new CCP clearing requirement; new margin requirements also apply to non-cleared OTC transactions.399 Increased margin/collateral costs may lead to a reduction in the volume of hedging transactions through derivatives, and to related prejudice to investor returns. Financial stability may also be implicated as the imposition of higher costs on hedging may lead to less efficient risk management (particularly were counterparties to be driven by EMIR to rely on exchange-traded (non-OTC), non-bespoke instruments which are less calibrated to hedging needs) and reduced market liquidity.

(p. 582) The risks of the new regime are exacerbated by the complexity of the issues engaged and the challenges they posed and continue to pose to the efficacy of the EU rule-making process. The design of the new clearing regime generated the most complex of technical challenges for the EU’s legislators, across structural (in terms of the shape of the new CCP and trade repository markets, and the impact of related competition and monopoly dynamics), substantive (including with respect to the classes of derivatives which should be subject to CCP clearing, the nature of CCP regulation and risk management, and the standardization of the risk mitigation techniques to be employed in bilateral clearing), and international (in terms of the interaction between the EU regime and other jurisdictions internationally) dimensions. The regulation of clearing and risk management was also something of a terra incognita for the EU, as it was for regulators internationally,400 although international standards were developed as the reform programme progressed.401 CCP regulation in the EU had previously been developed at national level and varied significantly, reflecting local market features and different CCP business models,402 while there was almost no experience with trade repository regulation.403

The design of EMIR may, however, reduce the risks of regulatory error. EMIR and its related administrative rulebook reflect the standards which have been developed internationally.404 In addition, the EMIR regime has been designed to support and strengthen the risk-management techniques developed by the OTC derivatives market, and it has accordingly sought to avoid replacing well-tried market practices with untested rules.405 The extensive calibrations within EMIR which are designed to reduce its costs, particularly for non-financial counterparties, provide a further means for reducing the risks of regulatory error, while the technical capacity which ESMA brought to the administrative rule-making process, and continues to bring to related supervisory convergence measures, provides another. A further corrective mechanism is in place in that an extensive review (p. 583) must take place before August 2015 (EMIR Article 85), although it remains to be seen whether the institutions will have the appetite for revision and reform.

(d)  Timing Issues

Although the 2012 EMIR came into force on 16 August 2012, its application in the market and the imposition of the core CCP clearing obligation has been protracted. The application of many of EMIR’s provisions depended on the entering into force of the related EMIR BTSs (which, for the initial swathe, took place on 15 March 2013).406 The pivotal CCP clearing requirement for particular OTC derivatives cannot come into effect until CCPs have been authorized and ESMA has made the consequent assessment of whether the classes of OTC derivatives which particular CCPs are authorized to clear should be subject to the CCP clearing obligation (section 4.2.6).407 Overall, the EMIR application timeline is complex, with different obligations being imposed on the market at different times.408 But the upshot has been that the EU has been relatively slow to move to mandatory CCP clearing: the US market moved to CCP clearing in 2012, but the EU was not expected to do so until the end of 2014—and later for non-financial counterparties.409

VI.4.2.2  The Evolution of the 2012 EMIR and the Crisis Context

While it has been shaped by the EU’s market, political, and institutional context, the 2012 EMIR is a direct product of the financial crisis and the September 2009 Pittsburgh G20 commitment that ‘standardized OTC derivative contracts’ would be cleared through CCPs and OTC derivative contracts reported to trade repositories.410

The EU had, however, from an early stage and pre-dating the September 2009 G20 commitment, placed OTC derivatives market reform on its crisis-era reform programme. The de Larosière Report of February 2009 called for the simplification and standardization of most OTC derivatives, greater market transparency, and, in a harbinger of the CCP clearing requirement, the establishment of at least one well-capitalized CCP for OTC CDSs.411 In the early stages of the OTC derivatives market reform programme, the stability (p. 584) and resilience of the CDS segment tended to preoccupy policymakers in the EU.412 The UK FSA’s 2009 Turner Review, for example, supported the establishment of CCP facilities in the CDS market,413 while the Commission initially focused on encouraging the industry to clear CDSs through CCPs.414 The drivers of the reform agenda’s move from CDS market resilience to the resilience of the OTC derivatives market generally, as it did over 2009, are not clear,415 and perhaps can be best explained in terms of momentum, a wider suspicion of innovation and speculation, and concerns as to regulatory arbitrage risks. High-level EU political support for OTC derivatives market reform was given by the June 2009 European Council,416 while the Commission’s July 2009 Communication and Consultation on derivatives market reform set out the main elements of OTC derivatives market reform, including central clearing, risk mitigation, and reporting requirements.417

Industry action was also taken. As the financial crisis deepened, the industry committed to move more OTC derivative transactions on to CCPs,418 and significant progress was made with respect to CDS clearing.419 But while the Commission was supportive of industry efforts to increase CCP clearing levels, it warned that stronger regulatory incentives were required.420

Subsequent to the September 2009 Pittsburgh G20 meeting, the Commission outlined the specific action to be taken in the EU on the foot of the G20 agenda.421 By the end of 2009, the Council had agreed on the need to improve the mitigation of counterparty credit risk, and to improve derivatives market transparency, efficiency, and integrity.422 The European Parliament similarly supported reform.423 Following some 18 months of consultation during which the main elements of what would become EMIR were flagged and examined (p. 585) in some detail,424 and extensive industry lobbying,425 the Commission’s Proposal for EMIR was presented in September 2010 (along with the Short Selling Proposal).426

The Proposal’s main features are reflected in EMIR. It proposed a wide-ranging CCP clearing obligation, applicable to OTC derivative transactions by financial and non-financial counterparties, the reach of which was to be determined through ‘top-down’ and bottom-up’ procedures; the Proposal mitigated the impact of the clearing obligation on non-financial counterparties through a threshold mechanism. The Proposal also contained risk mitigation requirements for non-CCP-cleared OTC derivative contracts and a reporting requirement for all OTC derivative contracts. These obligations were supported by authorization and supervisory regimes for CCPs and trade repositories. The Proposal did not change materially over the negotiations, although its scope became wider and the different calibrations and exemptions more nuanced.

The negotiations focused in the main on how EMIR’s costs could be mitigated and, in particular, on the application of the regime to OTC derivatives transactions by non-financial counterparties and the related mitigations and exemptions.427 The Parliament’s July 2011 negotiating position428 sought to calibrate the Proposal more finely to reflect the costs faced by non-financial counterparties and, ultimately, end investors.429 It also enhanced the Proposal’s provisions in relation to competition and access in the CCP market,430 and strengthened ESMA’s role, including by means of a more extensive set of delegations to BTSs and in relation to ESMA’s role in CCP colleges. Council negotiations focused closely on EMIR’s scope of application; in particular, the UK strongly supported the application of the CCP clearing obligation to listed derivative contracts traded on regulated markets, in order to ensure competition in relation to exchange-traded derivatives and to protect the City’s trading business (this has since followed under the 2014 MiFID II/MiFIR—see section 4.3).431 The extent of ESMA’s powers also proved contentious in the Council, particularly in relation to CCP authorization and supervision. The negotiations were coloured, generally, by the euro-area/internal market divide, with the UK concerned that EMIR would lead to a relocation of CCPs to the euro area. Following concessions to the UK designed to ameliorate its concerns as to (p. 586) euro-area dominance (these concessions related in particular to restrictions on the powers of CCP colleges in relation to CCP authorization and to easing CCP access to trading venues trade flows—see sections 4.2.9 and 4.2.6), and the UK’s agreement to drop its call for EMIR to cover regulated market-traded derivatives,432 the Council agreed on a compromise text in October 2011.433 Following difficult trilogue negotiations over October 2011–February 2012434 which focused in particular on third country CCP access requirements,435 the extent of the trade repository reporting obligation,436 and the role of the CCP college and of ESMA in CCP authorization,437 the European Parliament and Council adopted the text in March and April 2012, respectively.

VI.4.2.3  Harmonization and ESMA

The technical complexity and scale of most of the EU’s crisis-era legislative measures challenges the assumption that EU legislative measures are designed to address core regulatory principles and to reflect fundamental political decisions on the nature of market regulation (see further Chapter X section 3). With the 2012 EMIR, however, the crisis-era tendency to encrust legislative measures with technical detail perhaps reached its apotheosis. That said, EMIR’s detailed and complex operational rules reflect the scale of the EMIR reforms, the challenges which appropriate differentiation posed, and the technical nature of the risk-management rules on which EMIR is based. A degree of regulatory risk mitigation has been provided by the EMIR BTS rulebook which operationalizes EMIR, but which relies to a significant extent on criteria-based rules designed to build on tested market practice rather than on prescriptive rules. The regulatory risks are intensified, however, by the need to rely on soft law measures, notably the ESMA EMIR Q&A,438 to clarify the regime’s many operational implications, given the danger that NCAs may struggle in ensuring market compliance with operationally critical soft law measures.

The scale of amplification required under EMIR was immense. Some 21 or so of EMIR’s provisions were subject to detailed amplification, almost entirely through BTSs; the related EMIR administrative rulebook is currently composed of an array of delegated and implementing regulations.439 Additional administrative rules will be adopted in relation to the capital and collateral-related risk mitigation techniques for non-cleared OTC derivatives (Article 11(15)).440

(p. 587) ESMA’s supervisory convergence initiatives are also likely to be extensive, further thickening the EMIR regime. ESMA was, for example, quick to deploy the Q&A device in this area,441 has produced tailored information on EMIR for non-financial counterparties, and has adopted reporting templates.442 ESMA has also produced guidance on CCP interoperability, as required under EMIR (Article 54),443 and, on its own initiative, has produced guidance on the operation of the colleges of supervisors for CCPs.444

The administrative BTS rulebook, however, is at the heart of the EMIR regime. By contrast with the earlier, and similarly technically complex, 2011 AIFMD process, and in recognition of the growing stature and capacity of ESMA, the EMIR administrative regime took the form of BTSs, proposed by ESMA, rather than administrative rules adopted by the Commission in relation to which ESMA can only provide technical advice. ESMA was, accordingly, the driving influence on the regime.445

The BTS adoption process was potentially problematic on a number of grounds. The scale of the task, its complexity, and the short time limits for the adoption of the BTSs (ESMA’s initial consultation took place in March 2012 and the proposed BTSs were transmitted to the Commission at the end of September 2013)446 proved a significant challenge to ESMA, which was at the time also grappling with the rule-making demands of other major crisis-era measures, including the AIFMD. But a number of aggravating factors arose. As noted above, the regulation of OTC derivatives market clearing and risk management presented the EU with an enormous technical challenge, although the development of the BTS regime benefited from the availability, by that stage of the reform process, of international templates and guidance. The administrative regime accordingly reflects the FSB’s recommendations on implementing OTC derivatives market reform, and the related guidance and standards in relation to mandatory clearing requirements and CCPs.447 The international initiatives did not, however, provide the level of operational detail which the EMIR BTSs were charged with delivering.448 The difficulties were compounded by the lack of empirical evidence on many of the technical design issues.449

(p. 588) The development of the EMIR BTSs also required unusually close co-ordination between ESMA, EBA, the ESRB, the European System of Central Banks (ESCB), and the Agency for the Co-operation of Energy Regulators (ACER). Many of the BTS delegations required ESMA to co-operate with one or more of these authorities,450 given the systemic implications of the EMIR regime. Careful co-ordination was also needed with authorities with complementary mandates in relation to OTC derivatives market stability. The CCP BTSs, for example, were developed in close co-operation with the ESCB through a joint ESMA/ESCB task force.451 The ESCB is charged under the Treaty with the ‘basic task’ of promoting the smooth operation of payment systems (Article 127(2) TFEU). The central bank members of the ESCB accordingly oversee clearing and payment systems. While ESCB activities are closely concerned with payment-related activities and with securities settlement,452 ESCB members are also engaged with the authorization and monitoring of CCPs and the recognition of third country CCPs. ESCB members accordingly are integrated into EMIR’s supervisory oversight regime, forming part, for example, of CCP colleges,453 and being conferred with access rights in relation to trade repository information.454 Accordingly, close co-operation was required between ESMA and the ESCB in the development of BTSs in order to avoid the creation of parallel rules.455

The compressed BTS process456 was, however, relatively smooth, despite significant market opposition to some of ESMA’s proposals—notably, the approach ESMA took to margin and collateral457 and the approach it took to the clearing thresholds which govern the extent to which the EMIR CCP clearing obligation applies to non-financial counterparties.458 ESMA emerged from the process as pragmatic and flexible; while it was responsive to (p. 589) stakeholder concerns,459 it showed itself to be muscular in defending its position even in the face of opposition from other EU authorities, including the ESRB on occasion.460 All the required standards (with the exception of those relating to risk mitigation for non-CCP-cleared OTC derivatives and the application of the clearing obligation to contracts between third country counterparties (which were to be adopted at a later stage)) were submitted to the Commission for endorsement on 27 September 2012. They were (with one exception) agreed without change by the Commission on 19 December 2012, and came into force on 15 March 2013. The adoption of the BTS regime represents therefore an early and significant success for the BTS model. Nonetheless, the BTS regime generated significant institutional tensions which underline the stresses to which the BTS process is generally subject, and which tested the resilience of the inter-institutional procedures which are designed to resolve differences over the course of BTS adoption (see further Chapter X section 5.5).

The largely wholesale adoption by the Commission of a raft of rules of great market, operational, and international importance and sensitivity underlines the extent to which the Commission had become comfortable with the technical expertise and consultation capacity which ESMA brings to administrative rule-making. The EMIR BTS process thus stands in contrast to the adoption of the AIFMD administrative rules, in relation to which ESMA’s expert ‘technical advice’ (accordingly, not in the form of proposals for BTSs), which had been subject to impact assessment and market consultation, was in some respects rejected by the Commission, leading to great market disquiet. Two important points of difference arose between ESMA and the Commission under the EMIR process, however. The first relates to ESMA’s proposed RTSs on the operation of the colleges of supervisors which are closely engaged with the authorization and supervision of CCPs. ESMA proposed a standard designed to address the potential risk that an NCA could veto the establishment of a college. Under EMIR, a college can only be established once a CCP’s application for registration is complete; from that point, the college must be established by the CCP’s NCA within 30 days of receipt of the application. The college cannot be established, however, until all participants have agreed in writing the terms on which the college will operate (EMIR Article 18). In order to respond to the risk that a college member might choose not to agree with the written agreement in order to block the establishment of the college, ESMA proposed that the college be constituted in such circumstances, as long as the college could ensure that the voting procedures specified for the college under EMIR Article 19 could be implemented.461 The Commission rejected this standard462 on the grounds that it went beyond the mandate given under EMIR for specification of the details of the practical written agreement relating to the establishment and functioning of CCP colleges.463 It proposed instead that the RTS refer to the Commission’s power to take enforcement action, under Article 258 TFEU, where an NCA refused to participate in a college for which it was eligible. The Commission also proposed that the process for adopting the written agreement be strengthened by means of (p. 590) time limits for the adoption of the agreement and procedures for debating its content. As required under the ESMA Regulation, ESMA was given six weeks to amend the relevant CCP college RTSs on the basis of the Commission’s amendments and to resubmit the standards in the form of an opinion.

As the first application of the process governing differences between ESMA and the Commission in relation to the adoption of BTSs, the experience with respect to the CCP college RTS warrants some attention. The Commission’s decision to reject the standard suggests its sensitivity to overreach at the administrative level and its concern to ensure the parameters of the legislative measure are respected. It also underlines the Commission’s concern that national (NCA) discretion could be overridden without a resilient legal framework to support such an override. ESMA’s response is also instructive. ESMA was relatively robust in justifying its approach and suggested that Commission enforcement action before the Court of Justice was not compatible with the tight 30 day time limit for the establishment of colleges. It recognized, however, that its mandate was not broad enough to allow it to address appropriately the veto right which had inadvertently been introduced by EMIR, and was of the view that the Commission’s revisions were ‘sensible’ and that the implicit threat of enforcement action (underlined by a new recital to the RTS) was useful. It accepted therefore the Commission’s revisions and acknowledged that the veto difficulty could not be addressed until EMIR was reviewed.464 It is notable, however, that ESMA did not entirely abandon the issue, noting that it would suggest, through guidelines which would provide a template for the college agreement, that NCAs justify their decision not to agree to the terms of a college agreement; the guidelines were subsequently adopted in June 2013.465

A sharper BTS rejection, with potentially more serious implications for ESMA/Commission relations, issued from the Commission in relation to ESMA’s August 2013 proposal for an ITS to delay the start date for reporting to trade repositories in relation to exchange-traded derivatives (as required under EMIR Article 9). ESMA proposed the delay in order for it to have sufficient time to adopt related guidelines and recommendations governing the Article 9 reporting obligation generally.466 The Commission rejected the proposed ITS, arguing that it was not necessary to wait for ESMA guidelines, and, in trenchant language, argued that the postponement would ‘run counter to the principle of ensuring the stability of the financial system and the functioning of the internal market for financial services’.467 While the tone may have been unintentionally sharp, the robustness of the Commission’s response suggests some Commission concern to underline its primacy as the guardian of the EMIR regime. ESMA’s response was similarly robust, repeating its concern that a delay would benefit the application of the EMIR reporting requirement and emphasizing ESMA’s commitment to monitoring financial stability using accurate data, but also its concern to ensure EMIR-required data was accurate.468 While most of the EMIR rulebook (p. 591) is now in place, the potential for an uneasy Commission/ESMA relationship, given the tension between the Commission’s Treaty primacy as the location of administrative rule-making and ESMA’s de facto primacy as the location of technical expertise, remains considerable.

Potentially more serious difficulties arose over the BTS adoption process in relation to the European Parliament. Although the Parliament has from the outset been a robust supporter of ESMA, it remains sensitive to any threat to its legislative prerogatives. The scale, importance, and complexity of the EMIR BTS regime, in relation to which the Parliament was to be notified and over which it could exercise a veto, always made it likely that the EMIR BTS process could lead to tensions with the Parliament.

Following the procedure laid down by the 2010 ESMA Regulation (Chapter X section 5.5), the European Parliament had one month to examine the BTSs, which the Parliament extended, as it is empowered to do, by one month. Over that period, the Commission failed to respond to the Parliament’s comments on the text of the BTSs and failed to notify the Parliament that it had rejected one of the ESMA BTSs and had revised the timetable for the adoption of the standards (in that two sets of BTSs remained outstanding).

These procedural failures and substantive difficulties led to the European Parliament’s ECON committee proposing that the Parliament veto a number of the BTSs,469 in what would have been a major blow to the new BTS process; the veto would also have significantly delayed the EMIR timetable, complicating negotiations with the US on the interaction of the EU and US regimes.470 The ECON Committee’s concerns were twofold. First, it was concerned at a number of procedural weaknesses, including in relation to the limited time given to the Parliament and to the Commission’s failure to communicate effectively with the Parliament.471 Second, ECON raised a number of substantive concerns in relation to the BTSs. It was concerned in particular as to the impact of the proposed standards on non-financial counterparties472 and on their ability to manage risk effectively. It opposed, for example, ESMA’s method for calculating the thresholds at which a non-financial counterparty would become subject to the CCP clearing obligation as bringing too many non-financial counterparties, without systemic implications, within the costly CCP clearing obligation.473 It was also concerned that the BTSs did not sufficiently clearly ensure that non-financial counterparties below the CCP clearing threshold were not subject to the mark-to-market obligation which applied to other counterparties as a (p. 592) form of risk mitigation,474 and that an overly high standard had been applied to non-financial counterparties in relation to the portfolio reconciliation requirements which form part of the risk mitigation regime for non-CCP-cleared OTC derivatives,475 in relation to the electronic confirmations which form part of the risk mitigation regime,476 and in relation to the conditions applicable to the commercial bank guarantees which can be used by non-financial counterparties as collateral.477

A plenary debate on the motion which could have led to a European Parliament veto478 was averted, however, by a compromise between the Commission and ECON,479 under which the Commission acknowledged the Parliament’s concerns, committed to enhancing communications with Parliament in relation to the adoption of BTSs, and agreed to phase in EMIR’s obligations in relation to non-financial counterparties over ‘an appropriate period of time’.480 The Commission also acknowledged more generally that the development of BTSs was ‘terra nova’ for all the institutions involved and that the process would be refined over time.481 This led to the plenary vote being cancelled and cleared the way for the coming into force of the EMIR BTSs in March 2013.

These different fracas with respect to the EMIR BTS rulebook underline the instability in the BTS process, the importance of close institutional co-operation and communication, and the readiness of the European Parliament and Commission to flex their muscles. Overall, however, the development of the EMIR BTS administrative rulebook underlines ESMA’s capacity to capture and interrogate highly technical market data and to develop a practical set of rules which, by and large, have enjoyed market and institutional support.482 ESMA has also displayed an ability to capture market-developed risk-management tools and practices and to place them within a regulatory framework, thereby obviating the need for a highly prescriptive and potentially risk-laden rulebook; the BTSs are typically based on the application by the relevant actor of identified criteria rather than on the imposition of prescriptive rules.483 The BTS process has also underlined ESMA’s potential as an agent for ensuring administrative rules are appropriately calibrated in accordance with relevant legislative directions. In the development of the regime for non-financial counterparties, in particular, ESMA showed itself as sensitive to the operational and monitoring costs of the regime for small and medium-sized firms.484 Procedurally as well as substantively, the EMIR administrative rulebook is of some precedential importance.

(p. 593) VI.4.2.4  Setting the Perimeter: Scope

The 2012 EMIR lays down CCP clearing and bilateral risk-management requirements for OTC derivative contracts, reporting requirements for all derivative contracts, and uniform requirements for the performance of the activities of CCPs and trade repositories (Article 1).

Perimeter control under EMIR is in part a function of the contracting parties subject to its requirements. EMIR’s clearing and risk management and reporting requirements apply to financial counterparties.485 Non-financial counterparties486 are also, and controversially, subject to EMIR,487 but only when specified thresholds are passed (section 4.2.5).

EMIR takes a similarly broad approach to the derivatives within its scope which are very broadly defined by reference to the 2014 MiFID II/MiFIR regime.488 This alignment has, however, proved problematic, leading to ESMA raising concerns that difficulties with the consistent application of this core definition might prejudice the application of EMIR unless additional clarifying administrative rules are adopted; the Commission has promised urgent action.489 In practice, aside from the reporting obligation which applies to all derivatives, EMIR applies to OTC derivatives, or derivatives the execution of which takes place outside a MiFID II regulated market.490 EMIR accordingly applies to equity, credit, commodity, interest rate, and foreign exchange derivatives, despite significant industry pressure to reduce its scope.491

CCPs492 (and their clearing members493 and members’ clients494) and trade repositories495 also come within EMIR, and are subject to discrete regulatory regimes. Trading venues (p. 594) more generally come within EMIR, mainly with respect to the competition- and access-related provisions.

EMIR’s extraterritorial reach is wide. As outlined in section 4.2.13 of this Chapter, third country CCPs and trade repositories operating in the EU must be recognized by ESMA. The clearing, risk management, and reporting obligations imposed on counterparties also have an extensive reach. The CCP clearing obligation applies to contracts between EU financial/non-financial counterparties and an entity established in a third country that would be subject to the clearing obligation if it were established in the EU; it also applies to contracts between two entities established in third countries in these circumstances (Article 4(1)(a)). Similarly, the risk mitigation regime for non-CCP-cleared OTC derivatives has an extensive reach, applying to OTC derivative contracts entered into between third country entities that would be subject to those obligations if they were established in the EU, provided that the contracts have a direct, substantial, and foreseeable effect within EU, or where such obligation is necessary or appropriate to prevent the evasion of any EMIR provision (Article 11(12)). While these requirements are, in practice, anti-avoidance mechanisms designed to prevent EU entities from structuring contracts to avoid EMIR, they underline EMIR’s potential reach.

Although the regime is calibrated, particularly in relation to how it applies to non-financial counterparties, there are also three sets of exemption from its scope; while the exclusion of these actors from EMIR reflects different concerns in each case, all three exemptions are broadly related to market efficiency.

Entities engaged in the management of public debt—in particular the members of the ESCB, other Member State bodies performing similar functions, and EU public bodies charged with or intervening in the management of public debt—and the Bank for International Settlements are excluded from EMIR’s scope (Article 1(4)) in order to ensure that EMIR does not prejudice the smooth operation of monetary functions. In addition, multilateral development banks, public sector entities, and the European Stability Mechanism are exempted from EMIR, with the exception of the Article 9 reporting requirements (Article 1(5)). Third country central banks and public entities managing public debt were originally not addressed by this exemption, pending greater clarity on how jurisdictions internationally would treat these entities as their OTC derivatives regimes developed. In 2013, the Commission, in the report required under Article 1(6), reported that major third countries typically exempted these entities from the scope of the new OTC derivatives market rules, and recommended that the EU accordingly extend this exemption.496

The second exemption has a narrower focus and exempts intra-group derivatives transactions. Such transactions may be used to aggregate risk within a group, and submitting them to the CCP clearing obligation may limit their efficiency. The intra-group exemption is therefore available where conditions designed to mitigate potential systemic risk are met, and in order to support efficient intra-group risk management (Article 3). The exemption is available for non-financial counterparties in relation to an OTC derivative contract entered (p. 595) into with another counterparty which is part of the same group, as long as both counterparties are included in the same consolidation on a full basis and are subject to an appropriate, centralized risk evaluation, measurement, and control procedure, and the counterparty is established in the EU (Article 3(1)).497 The intra-group exemption is also available to financial counterparties, subject to an extensive series of conditions designed to mitigate risks (Article 3(2)). The intra-group exemption applies in relation to the CCP clearing obligation (Article 4) and to elements of the risk mitigation regime for non-CCP-cleared transactions (given the heightened systemic risk thereby engaged, the collateralization requirements are lifted only where specific requirements are met), subject to notification of and agreement by the relevant NCA (Article 11). The exemption does not apply to the Article 9 reporting obligation.

A final and limited exemption applies to pension scheme arrangements.498 Over the EMIR negotiations, pension funds successfully argued that their derivatives activities are related to the management of inflation and volatility and are not speculative, and that EMIR’s requirements, and in particular the CCP margin requirements which would require pension funds to hold significant cash funds, would damage returns to pension holders.499 A transitional, three-year exemption is accordingly available: identified occupational pension funds500 benefit from an exemption from the CCP clearing requirement until 15 August 2015 (Article 89). This exemption may be extended for a further two years and a final one-year term, subject to the Commission agreeing, and pending the adoption of a technical solution related to the difficulties posed to the pension fund industry by EMIR’s margin requirements (Article 85(2)).

VI.4.2.5  Calibration and non-Financial Counterparties

The wide scope of the 2012 EMIR generated significant industry concern during the negotiations.

Financial counterparties which typically relied on OTC derivatives for hedging purposes, rather than for speculative purposes, raised concerns as to the potential costs and prejudice to efficient risk management arising from the costly collateral and margin requirements. Property fund managers, for example, come within EMIR as AIFMD-scope managers. They use interest rate swaps to hedge interest risk when they fund property investments through floating rate loans. EMIR’s CCP clearing and risk-management rules for non-CCP-cleared transactions (particularly in relation to collateral and margin) have the potential to impose significant costs on this core hedging activity and to damage returns.501 But among financial counterparties, only pension funds were successful in negotiating an exemption from EMIR.

(p. 596) Greater calibration applies to non-financial counterparties. Non-financial counterparties have not been granted a full exemption from EMIR, given their importance in the OTC derivatives market and the potential for systemic risk from some non-financial counterparties—as well as the regulatory arbitrage risks which could be generated by such an exemption, given the incentives for financial counterparties to operate through non-financial counterparties.502 But EMIR could potentially impose significant costs on efficient hedging activities related to commercial activities and to treasury/funding activities503 which do not pose systemic risks;504 the European Parliament’s concern as to the costs which ESMA’s proposed BTSs could impose on non-financial counterparties was a major driver of its initial threat to veto the standards.

The calibration of EMIR’s application in order to protect commercial and treasury hedging by non-financial firms is achieved by means of the ‘clearing threshold’ mechanism (calibration is also provided by the extended ‘phase-in’ of the CCP clearing obligation for non-financial counterparties).505 This threshold acts as a proxy for sporadic and/or non-systemically significant derivatives activity. Non-financial counterparties under the threshold are subject only to the EMIR reporting obligations and to a lighter risk mitigation regime. But where a non-financial counterparty takes positions in OTC derivative contracts and those positions exceed the threshold, the counterparty must notify ESMA and the NCA immediately, becomes subject to the CCP clearing obligation for all future contracts (and not only in relation to the particular positions which breached the clearing threshold),506 and must clear all relevant future contracts (whether for hedging purposes or not—hedging contracts within the terms of EMIR are, as noted below, excluded from the clearing threshold calculation)507 within four months of becoming subject to the clearing obligation (Article 10(1)).

The calculation of the clearing threshold is accordingly pivotal to EMIR’s scope of application. It is governed by EMIR Article 10 and its related BTSs. The regime is designed to ensure that non-financial counterparties only become fully subject to EMIR where their activities become systemically significant, and to protect hedging activities related to usual commercial and or treasury financing activities. The concern to protect hedging activities is implicit in the Article 10 calculation procedure, which provides that the position (p. 597) calculation for the purposes of establishing whether positions exceed the threshold must include all OTC derivative contracts entered into by the non-financial counterparty (or other non-financial entities within the group) which are not objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activities of the counterparty (Article 10(3)). The BTSs which govern whether a derivative transaction meets the Article 10(3) hedging requirement are broadly based,508 and reflect ESMA’s concern that the carve-out reflect the range of risks which commercial and treasury funding operations generate,509 the flexibility needed by non-financial counterparties,510 and the need to reduce the costs faced by non-financial counterparties in monitoring their positions for the purpose of the clearing threshold;511 this concern was also evident in ESMA’s development of the clearing thresholds. Nonetheless, the standards generated significant differences of opinion over the consultation process512 and led to a difference of opinion between ESMA and the ESRB.513

The clearing thresholds against which derivative positions are to be monitored were to be established by ESMA by taking into account the systemic relevance of the sum of the net positions and exposures per counterparty and per class of OTC derivative (Article 10(4)). The breadth of the definition of excluded hedging contracts has led to the clearing thresholds being set at a relatively low level,514 although the thresholds are to be regularly reviewed (Article 10(4)). The clearing thresholds apply in relation to credit derivatives (€1 billion in gross notional value), equity derivatives (€1 billion), interest rate derivatives (€3 billion), foreign exchange derivatives (€3 billion), commodity derivatives (€3 billion), and other OTC derivative contracts (€3 billion).515 ESMA’s tying of the threshold to a (p. 598) gross notional value assessment led to significant industry and European Parliament opposition, and to calls for the calculation to be based on a net, mark-to-market value on the grounds that this would allow the systemic risk represented by OTC derivative positions to be more accurately captured (and would have given non-financial counterparties more leeway to stay under the threshold). Despite the potential for institutional tensions,516 ESMA argued that a gross notional value was easier to implement and assess than a mark-to-market value and provided greater stability and certainty in the assessment of positions, particularly for small and medium-sized firms. ESMA also underlined that the absence of reliable data on net positions led it to conclude that gross value was a reasonable and practical proxy for systemic relevance.517

VI.4.2.6  The Clearing Obligation

At the heart of the 2012 EMIR is the Article 4 obligation on counterparties to clear518 all OTC derivatives contracts pertaining to a class of OTC derivatives519 that has been declared subject to the clearing obligation in accordance with the Article 5(2) procedure through a CCP (Article 4(1)). These contracts must be cleared through an EU-established CCP authorized under EMIR (Article 14) or a third country CCP recognized by ESMA (Article 25), in each case authorized to clear the relevant class of OTC derivatives and listed in the Article 6 ESMA-maintained public register (Article 4(3)). In order to support the clearing obligation, the counterparty must become a clearing member or a client, or establish indirect clearing arrangements with a clearing member (Article 4(3));520 the clearing obligation cannot thus be avoided by a counterparty not engaging with a CCP. Article 4(3), which provides for a range of clearing access models, is designed to respond to the heavy costs associated with becoming a clearing member, given the capital, margin, and default fund requirements which apply (section 4.2.10), and to support structural change within the clearing industry by encouraging the development of new, indirect clearing access routes.

The obligation has a wide reach (Article 4(1)). It applies in relation to contracts concluded between the following: two financial counterparties; a financial counterparty and a non-(p. 599) financial counterparty over the clearing threshold; and two non-financial counterparties over the clearing threshold. The extraterritorial reach of the clearing obligation is supported by its application to contracts between the following: a financial counterparty or non-financial counterparty over the clearing threshold and an entity established in a third country that would be subject to the clearing obligation if it were established in the EU; and two entities established in one or more third countries that would be subject to the clearing obligation if they were established in the EU, as long as the contract has a ‘direct, substantial and foreseeable’ effect within the EU, or where such an obligation is necessary or appropriate to prevent the evasion of EMIR.521

It does not, however, apply to non-financial counterparties below the clearing threshold, pension scheme arrangements (on a transitional basis, Article 89), or intra-group transactions (Article 4(2)). The intra-group exemption is dependent on the counterparties in question having notified their NCAs of their intention to use the exemption and the NCAs not having objected to reliance on the exemption where the conditions governing the exemption (Article 3) are not met.522

The identification of the classes of derivatives subject to the clearing obligation has major structural and cost implications for the OTC derivatives market in the EU. It also has implications for CCPs’ resilience and their ability to manage the related systemic risks associated with central clearing; the more complex the class of derivative cleared, the greater the pressure on the CCP’s risk-management systems—particularly its processes for valuing margin—and, accordingly, on the EMIR rulebook. The process governing which classes of OTC derivatives are subject to the clearing obligation has two elements: the ‘bottom-up’ (or industry-driven) procedure and the ‘top-down’ procedure (ESMA-driven). Both procedures were a feature of EMIR from the earliest Commission consultations, and are also a feature of IOSCO’s standards on mandatory clearing.523

The ‘bottom-up’ procedure (Article 5(1) and (2)) is driven by the CCP authorization process (section 4.2.9) and so links the clearing obligation to CCP practice, and to whether the CCP has appropriate risk management and other procedures in place to clear identified classes of OTC derivatives safely. Once an NCA has authorized a CCP to clear a class of OTC derivatives, it must inform ESMA of the authorization; public disclosure is made of elements of the related and extensive notification which the NCA must make to ESMA524 in order to signal to the market that a potential CCP clearing obligation may arise.525 ESMA is then required to decide whether that class of derivatives should be subject (p. 600) to the Article 4 CCP clearing obligation for all relevant counterparties. Procedurally, the determination is made by means of ESMA—following a public consultation, and after consulting the ESRB and, where relevant, competent authorities of third countries—submitting RTSs for Commission endorsement which specify the class of OTC derivatives to be subject to the CCP clearing obligation and the application date (Article 5(2)). In deciding whether to subject a class of OTC derivatives to the CCP clearing obligation, and with the overarching aim of reducing systemic risk, ESMA’s assessment must extend beyond the NCA’s original assessment of whether the particular CCP can clear the class in question and address the market-wide implications of subjecting the asset class to a general CCP clearing obligation.526 Accordingly, ESMA must take into consideration the degree of standardization of the contractual terms and operational processes of the relevant class;527 the volume and liquidity of the relevant class;528 and, of particular importance to the ability of the CCP to make optimum risk-management decisions, the availability of fair, reliable, and generally accepted pricing information on the relevant class (Article 5(4)).529 ESMA may also take into consideration the interconnectedness of the counterparties using the relevant class, the anticipated impact on levels of counterparty credit risk,530 and the impact on competition across the EU (Article 5(4)). There are suggestions within EMIR that the CCP clearing obligation is primarily designed to address counterparty credit risk, and that this may lead to a narrowing of the scope of the clearing obligation; EMIR suggests that for certain classes of OTC derivative the key risk may be settlement risk, and that accordingly CCP clearing, which it identifies as addressing counterparty credit risk, may not be the optimal solution.531

EMIR also specifies the criteria which ESMA must take into account in deciding the date from which the CCP clearing obligation should apply.532

The changed regulatory environment following the G20 reform agenda, and regulatory pressure on the industry to pre-empt the adoption of binding CCP clearing requirements, has led to a wider range of asset classes and volumes of OTC derivatives being cleared (p. 601) through CCPs.533 The ‘bottom-up’ procedure, which follows market practice, is likely, as a result, to lead to an extensive CCP clearing obligation.534

The ‘top-down’ procedure, which is designed to follow the ‘bottom-up’ procedure, has the objective of ensuring that CCP clearing applies to particular classes of OTC derivatives which are not, in practice, cleared through CCPs (and so not picked up through the bottom-up process) but are deemed as systemically relevant—although central to the design of the top-down procedure is the assumption that no CCP will be required to clear derivatives unless it can safely do so. The top-down process can also be associated with regulatory encouragement of the market to provide appropriate clearing facilities.535 ESMA can independently, and after public consultation and consulting the ESRB (and third country competent authorities, as relevant), identify and notify to the Commission the classes of derivatives that should be subject to the Article 4 clearing obligation, but in respect of which no CCP has received authorization (Article 5(3)).536 But, given the risks of requiring CCPs to clear instruments which have yet to be cleared in practice by a CCP, the ‘top-down’ procedure is likely to be more peripheral to the clearing obligation process.

EMIR does not clearly address how the CCP clearing obligation can be withdrawn. Where the conditions which qualify an instrument no longer apply, financial stability demands that the obligation be lifted. ESMA is, however, subject to the usual (cumbersome) RTS procedure when removing an instrument from the obligation. A tailored, accelerated procedure may, accordingly, be required.

A series of allied obligations support the CCP clearing obligation. Least intrusively, public disclosure requirements apply, in that ESMA must maintain a related public register (Article 6).537 More intrusively, access- and competition-related protections apply in relation to access to CCP clearing, which are designed to promote competition between CCPs and the liberalization of access to CCP clearing services and to protect against discrimination by vertically integrated trading venue/CCP silos.538 The original provision (EMIR Article 7) has been amended by the 2014 MiFIR (Article 53) to reflect the refinements which MiFIR made to CCP/trading venue access rights generally (noted in (p. 602) Chapter V section 13). As revised, Article 7 provides that, with respect to CCP access, where a CCP has been authorized to clear particular OTC derivatives, it must accept the clearing of such contracts on a non-discriminatory and transparent basis, including as regards collateral requirements and fees relating to access, regardless of the trading venue on which the derivative contracts trade. In particular, a trading venue (in practice, an MTF or OTF) has the right to non-discriminatory treatment in terms of how contracts traded on that trading venue are treated in terms of collateral requirements and netting of economically equivalent contracts (where the inclusion of such contracts in the CCP’s close-out and other netting procedures, based on the applicable insolvency law, would not endanger the smooth and orderly functioning, the validity, and/or the enforceability of such procedures), and of cross-margining with correlated contracts cleared by the same CCP under a risk model that complies with EMIR Article 41 (which addresses margin and collateral: section 4.2.10).539 A CCP may, however, require that a trading venue comply with the operational and technical requirements established by the CCP, including risk-management requirements. Refusals of access must be reasoned, and the CCP (and the CCP’s NCA) may only refuse access where access would threaten the smooth and orderly functioning of the markets or adversely affect systemic risk (Article 7). Similarly, EMIR protects the provision of trading venues’ trade feed data to CCPs, in order to ensure vertical silos do not discriminate against CCPs and to enhance overall liquidity by broadening market participant access to trading venues by means of allowing access by multiple CCPs.540 Under Article 8, a trading venue must provide trade feeds on a non-discriminatory and transparent basis to any CCP that has been authorized to clear OTC derivative contracts traded on that trading venue (in practice, an MTF or OTF) upon request by the CCP. Access by the CCP to the trading venue can only be granted, however, where it would not require interoperability or threaten the smooth and orderly functioning of markets, in particular due to ‘liquidity fragmentation’, and the trading venue has put in place adequate mechanisms to prevent such fragmentation.541

VI.4.2.7  The Risk Mitigation Obligation for non-CCP-cleared Derivatives

Where OTC derivatives are not subject to the CCP clearing obligation, a series of risk mitigation obligations542 apply to financial counterparties and to non-financial counterparties above the clearing threshold; a calibrated regime applies to non-financial counterparties below the clearing threshold (Article 11). These risk mitigation requirements are designed (p. 603) to reduce counterparty risk and operational risk, as well as to enhance and strengthen the collateralization of these transactions and, in so doing, to reflect the risk-management techniques which the OTC markets have developed for bilaterally cleared derivative contracts.543

All financial and non-financial counterparties are required to ensure, exercising due diligence, that appropriate procedures and arrangements are in place to measure, monitor, and mitigate operational risk and counterparty credit risk (Article 11(1)). These procedures and arrangements must include timely confirmation, where available by electronic means, of the terms of the contract, and formalized processes, which are robust, resilient, and auditable, to reconcile portfolios, to manage the associated risk, to identify and resolve disputes between parties early, and to monitor the value of outstanding contracts.544

Additional and more stringent requirements apply to financial counterparties and non-financial counterparties above the clearing threshold. Financial counterparties and non-financial counterparties above the threshold must mark-to-market on a daily basis the value of outstanding contracts; where market conditions prevent marking-to-market, a reliable and prudent marking-to-model must be used (Article 11(2)).545

Collateral requirements also apply. Financial counterparties must have in place risk-management procedures that require the timely, accurate, and appropriately segregated exchange of collateral with respect to OTC derivative contracts (which are entered into on or after 16 August 2012) (Article 11(3)).546 Non-financial counterparties above the threshold must similarly have collateral exchange procedures in place in relation to contracts entered into on or after the clearing threshold is exceeded (Article 11(3)). Financial counterparties are additionally required to hold an appropriate and proportionate amount of capital to manage the risk not covered by appropriate exchange of collateral (Article 11(4)). The intra-group exemption is available in relation to the collateralization requirements, but only where broadly functional substitutes are in place.547

Like the CCP clearing obligation, the risk mitigation regime has an extensive reach, applying to OTC derivative contracts entered into between third country entities that would be subject to those obligations if they were established in the EU, provided that the contracts have a direct, substantial, and foreseeable effect within the EU, or where such obligation is necessary or appropriate to prevent the evasion of any EMIR provision (Article 11(12)).

(p. 604) VI.4.2.8  The Reporting Obligation

The 2012 EMIR’s extensive reporting regime for derivatives, which is designed to provide regulators and market participants with significantly greater transparency on the scale and nature of derivatives market activity and related exposures, applies to all counterparties (financial and non-financial) and to CCPs. They must ensure that the details of any derivative contract they have concluded (whether or not OTC and whether cleared or not), and of any modification or termination of the contract, are reported to an ESMA-registered or -recognized trade repository (or to ESMA, where a trade repository is not available) no later than the working day following the contract conclusion, modification, or termination (Article 9).548 The reporting obligation may be delegated by the counterparty or CCP, but CCPs and counterparties must ensure that contract details are reported without duplication. Counterparties must also keep a record of any derivative contract they have concluded and any modification thereto for at least five years following contract termination.

VI.4.2.9  The CCP Regime: Authorization and the CCP College

The resilience of the new CCP clearing regime depends on the resilience of the CCPs through which a massive volume of OTC derivatives will be cleared. Accordingly, a highly detailed regulatory regime, closely focused on prudential regulation, applies to the CCPs through which the Article 4 clearing obligation is met. Although much of the regime is based on the 2012 CPSS-IOSCO Principles for Financial Market Infrastructure, it is significantly more detailed than the Principles and engages with EU-specific risks, including in relation to cross-border supervision.

The CCP authorization process is distinct from other authorization regimes across EU securities and markets regulation with respect to the significant constraints it places on what is normally the exclusive power of an NCA with respect to authorization decisions. During the early negotiations on what would become the 2010 ESMA Regulation, the possibility of ESMA authorizing and supervising CCPs was raised by the 2009 DLG Report549 and accepted by the Commission and Council, albeit that some Member States, from the outset, were opposed given the fiscal risk associated with CCPs. The subsequent EMIR negotiations led to a closer focus on the nature, location, and extent of CCP risks, and to a more nuanced authorization process which attempts to balance the national interest in ensuring authorization/supervisory decisions with fiscal implications are located at national level and the cross-border interest in the effective supervision of CCPs.

CCP authorization and supervision remains a national competence, given the very significant fiscal risks which CCP failure would generate for the Member State in which the CCP is based. But the pan-EU systemic risks are acute, with the Member States of the clearing members of a failed CCP likely to be the first impacted by any CCP default.550 In addition, discriminatory practices with respect to CCP access have the potential to disrupt the EU (p. 605) market. Accordingly, EMIR provides for a CCP college of NCAs which can exercise material powers with respect to CCP authorization. The CCP authorization process triggers the creation of a college of NCAs which is required to adopt an opinion on the authorization, and which can veto the local NCA’s decision to authorize the CCP.551 The operation of the college is addressed by Commission Delegated Regulation 876/2013552 and co-ordinated through ESMA, whose related activities have included the development of a framework written agreement governing the college, a common risk assessment template, and a model for the composition of CCP colleges.553

The CCP authorization application must be made to the NCA of the Member State within which the CCP is established; once granted, authorization is effective pan-EU (Article 14(1) and (2)). As is common across EU securities and markets regulation, and in order to mitigate risks, CCP authorization is tied to particular activities; authorization can be granted only for activities linked to clearing, and the authorization must specify the services in relation to which the CCP is authorized and the classes of financial instrument covered by the authorization (thereby supporting ESMA’s subsequent assessment of whether a mandatory clearing obligation should apply in relation to those financial instruments) (Article 14(3)). Where a CCP wishes to extend its business, express authorization must be granted by the NCA (Article 15). Authorization conditions are not specified in detail under EMIR; Member States are expressly empowered to adopt (or to continue to apply) additional requirements in relation to CCPs established on their territories (Article 14(5)). EMIR simply provides that the applicant CCP must submit an application to the NCA of the Member State where it is established which provides all information necessary to satisfy the NCA that it has established, at the time of authorization, all the necessary arrangements to satisfy EMIR’s requirements (Article 17(1) and (2)). EMIR does require, however, that the CCP be notified as a system under Directive 98/26/EC (Article 17(4)),554 and specifies the minimum capital requirements for CCPs (Article 16). A CCP must have initial permanent and available capital of €7.5 million. Its capital overall, including retained earnings and reserves, must be proportionate to the risks stemming from its activities, and must at all times be sufficient to ensure an orderly winding down or restructuring of activities over an appropriate time span and an adequate protection of the CCP against credit, counterparty, market, operational, and business risks (which are not already covered by the specific financial resources required of the CCP under Articles 41–44, as discussed later in the Chapter).555

The procedure for authorizing a CCP allows the CCP’s college of supervisors (acting unanimously) to override the local NCA. The submission of an authorization application by a CCP triggers the formation of a college. With 30 days of the submission of a complete (p. 606) application, the CCP’s NCA must establish, manage, and chair a large college of supervisors, the members of which are specified by EMIR (Article 18(1)).556 The establishment and functioning of the college is based on a written agreement between its members which determines the practical arrangements for the functioning of the college, including detailed voting procedures (Article 18(5)). The CCP’s NCA must transmit all information received from the CCP to ESMA and to the college and, after assessing that the application is complete, notify the college, ESMA, and the applicant accordingly (Article 17(3)).

The NCA may grant authorization only where it is fully satisfied that the CCP complies with all the requirements laid down under EMIR and where the CCP college has not exercised its veto (Article 17(4)); in making its decision the NCA must consider the risk assessment required of the college in relation to the CCP (Article 19).557 Where the NCA does not agree with a positive opinion (risk assessment) from the college, it must provide reasons for its deviation from the assessment. A CCP may not be authorized where all the members of the college (excluding the CCP’s NCA) reach a unanimous joint opinion (which sets out full and detailed reasons) that the CCP not be authorized.558 The CCP NCA may, however, refer the refusal to ESMA for binding mediation. Where the joint opinion against authorization has been adopted by a two-thirds majority of college members, any college member which does not support authorization may request binding ESMA mediation. The CCP’s NCA must suspend the authorization decision until ESMA’s decision. Underlining the pivotal nature of the authorization decision, ESMA is also expressly (if somewhat otiosely) empowered to take enforcement action559 against the CCP’s NCA where the authority has not applied EMIR or has applied it in a way which appears to be in breach of EU law (Article 17(5)).

The sensitivity of these unusually intrusive college powers is well illustrated by the voting thresholds specified and by the graduated consequences which follow, as well by the requirement for college members not to directly or indirectly discriminate against any Member State or group of Member States as a venue for clearing services in any currency (Article 17(6)).

The CCP college is also engaged with decisions to withdraw authorization.560 Where the CCP’s NCA considers that there are grounds for withdrawal of authorization (which may (p. 607) be limited to particular services, activities, or classes of financial instrument), it must notify ESMA and college members and consult with the college; the college may not exercise a veto, but where the NCA’s decision departs from college members’ positions, the NCA must take into account the reservations of college members in adopting its reasoned decision on withdrawal. College members may also request the CCP’s NCA to examine whether the CCP remains in compliance with its authorization conditions (Article 20).

Once authorized, a CCP must at all times comply with the authorization conditions and notify the CCP’s NCA of any material changes affecting the authorization conditions (Article 14(4)). Where the CCP wishes to extend its business into another Member State, the CCP’s NCA must immediately notify the NCA of that State (Article 15(2)).

Third country CCPs may only provide clearing services to clearing members or trading venues established in the EU where they are recognized by ESMA, under a process akin to authorization (section 4.2.13).

VI.4.2.10  CCP Regulation

An extensive organizational, conduct, and prudential regime, which includes detailed administrative rules based in part on the 2012 CPSS-IOSCO Principles for Financial Market Infrastructures and which reflects close co-operation between ESMA and the ESCB, governs authorized CCPs. The regime is designed to contain the significant systemic risks which CCPs pose to the EU financial system and to minimize the risk that a large-scale tax-payer bailout, which a default would likely trigger, could be required. Although CCPs performed well over the financial crisis, the new clearing obligation significantly changes the nature and scale of the risks they face and pose. The potential for radical structural change which the 2012 EMIR brings generates further risks in relation to the CCP industry; a proliferation of CCPs could lead to the generation of poor incentives and hinder transparency.561

The organizational rules include a range of requirements designed to enhance risk management and to support the generation of strong CCP incentives to manage risk appropriately, given potentially perverse commercial incentives. These include requirements relating to organizational structure and internal control mechanisms; compliance procedures; continuity; effective resources, systems, and procedures; separation of risk management and other reporting lines; remuneration policy;562 IT requirements; and frequent and (p. 608) independent audit (Article 26).563 Board governance is addressed through independence and expertise requirements (Article 27); CCPs must also establish an independent risk committee (composed of representatives of clearing members and clients and of the board’s independent members, but NCAs may request to attend in a non-voting capacity) to advise the board on a range of risk-management issues (Article 28). Senior management is also addressed, and is subject to a requirement for sufficient experience to ensure the sound and prudent management of the CCP (Article 27). Qualifying shareholders, any close links between the CCP and other natural or legal persons, and the acquisition or disposal of qualifying shareholdings are subject to a review regime similar to that which applies under the 2014 MiFID II (Article 30). The organizational regime also includes record-keeping (Article 29), conflicts of interest management (with respect to conflicts of interest between the CCP and its clearing members and clients) (Article 33), business continuity (Article 34), and outsourcing (Article 35) rules, in all cases tailored to the particular operational risks to which CCPs are exposed.

The conduct-of-business regime addresses the particular conduct risks associated with CCPs and the appropriate protection of CCP clearing members and clients (many of the new rules reflect the asset segregation risks which were exposed by the Lehman Brothers collapse), and so covers fair treatment and complaint handling (Article 36); CCP participation requirements (Article 37);564 transparency requirements, including with respect to fees and prices, the risks associated with the services provided, and volumes of cleared transactions (Article 38); and segregation and portability of CCP records and accounts (Article 39). EMIR’s asset segregation rules also form a central element of EMIR’s support of CCP stability by requiring that the assets of clearing members are clearly distinguishable so that in a default the affected assets can be identified and losses contained.

EMIR’s prudential regime is primarily concerned with the management of default by CCP members and with the ability of the CCP to replace trades and sustain associated losses. The CCP’s ability to absorb losses arising from the default of a clearing member is supported through an array of funding-related measures which together provide a graduated scale of resources that can be called on by the CCP where it is required to replace trades.

At the base of the loss absorption regime are the margin and collateral requirements (described by EMIR as the CCP’s ‘primary line of defence’)565 which are designed to ensure that the CCP has access to margin in the form of high-quality collateral (and to provide strong risk-management incentives for CCP members, given the costs of margin). Margin and collateral rules must, however tread a fine line between ensuring a CCP is adequately resourced against default and imposing overly stringent and costly rules on CCP members which shrink the pool of available collateral and increase costs. EMIR manages (p. 609) this balance mainly through the EMIR BTS regime, which establishes a number of criteria for the margin assessment by CCPs, but does not specify the particular approach to be adopted by CCPs.566 The regime is designed to determine the minimum percentages that margins567 should cover for different classes of financial instruments, to establish principles which CCPs should follow in tailoring margin levels to the characteristics of each financial instrument or portfolio cleared, and to ensure that CCPs do not, in an EMIR-driven competitive CCP environment, reduce margin to a level that compromises safety.568 The regime is based on the core requirements that: margins are sufficient to cover the potential exposures that the CCP estimates will occur until the liquidation of the relevant positions; margins are sufficient to cover losses from at least 99 per cent of the exposures’ movements over an appropriate time horizon; and margins ensure that the CCP fully collateralizes its exposures with clearing members (and CCPs with which it has interoperability arrangements) (EMIR Article 41). The CCP must regularly monitor and (where necessary) revise the level of margins to reflect current market conditions, taking into account any potentially pro-cyclical effects of revisions.569 While the regime is based on the CCP making the margin decision, the stringency of some of the key criteria570—which, in some respects, departed from international standards by imposing more onerous requirements571—generated significant industry hostility given the sharp impact of margin requirements on costs, and the heavier cost burden and competitive disadvantages with which the stringent EU margin regime has been associated.572

(p. 610) At the heart of the related and extensive regime on the type and quality of collateral which a CCP can accept as margin (and as default fund contributions – noted in this section) is the requirement that the CCP must require ‘highly liquid’ collateral, with minimal credit and market risk, to cover its initial and ongoing exposure to its clearing members (Article 46);573 a CCP may also accept, where appropriate and sufficiently prudent, the underlying of the derivative contract or financial instrument that originates the CCP exposure as collateral to cover its margin requirements. As with the margin calculation regime, ESMA’s approach to the related BTSs governing collateral574 proved contentious both with the market and institutionally.575 The BTSs provide that only cash, financial instruments, commercial bank guarantees (for non-financial counterparties), and gold can be considered as ‘highly liquid’,576 despite market support for eligible collateral also to include other commodities, the units of UCITSs and alternative investment funds, and all collateral accepted by central banks or with a minimum credit rating.577

Significant controversy attended the rules governing collateral posted by non-financial counterparties, which are designed to provide some flexibility and to minimize the costs of collateral for these actors; specifically, for non-financial counterparties, a CCP can accept commercial bank guarantees (Article 46(1)), but ESMA’s approach to the eligibility of commercial bank guarantees578 generated significant market hostility579 and the threat of a veto from the European Parliament.

The margin and collateral regime is supported by the requirement for a ‘default fund’ (Articles 42 and 45). To limit its credit exposure, a CCP must maintain a pre-funded default fund to cover losses that exceed the losses covered by margin requirements; the default fund requirements cover, inter alia, contributions to, size of, coverage of, and resilience of the fund.580

(p. 611) A third line of defence against default is the requirement imposed on a CCP to maintain ‘sufficient pre-funded available financial resources’ to cover potential losses that exceed the losses to be covered by the margin requirements and the default fund (Article 43).581 The default fund and the ‘other financial resources’ must at all times enable the CCP to withstand the default of at least the two clearing members to which it has the largest exposures under extreme but plausible market conditions (Article 43(2)).

Finally, the CCP’s capital (Article 16) provides a last-resort resource available to absorb losses from a clearing member’s default: the CCP’s capital—‘other financial resources’ cannot be relied on to meet the Article 16 capital requirement (Article 43(1))—is required to be at all times sufficient to ensure an orderly winding down or restructuring of activities over an appropriate time span and an adequate protection of the CCP against credit, counterparty, market, operational, legal, and business risks which are not covered by the specific financial resources related to margin, the default fund, and other financial resources (Article 16(2)).

The priority in which the CCP can call on margin, the default fund, and other financial resources is specified by the ‘default waterfall’ (Article 45), which determines the order in which contributions by defaulting and non-defaulting members, and the CCP’s dedicated own resources, are to be used.582 Article 48 governs the procedures applicable on a default, including with respect to the management of the default (including in relation to the containment of losses and liquidity pressures and the avoidance of disruption to CCP operations), NCA notification, the enforceability of default procedures (including in relation to the liquidation of the proprietary positions of a defaulting member), the treatment of the clearing member’s clients’ positions, and the appropriate use of clients’ collateral (Article 48).

Extensive related risk assessment and management requirements apply. The exposure management rule (Article 40), for example, requires a CCP to measure and assess its liquidity and credit exposures to each clearing member (or to another CCP, where the CCP has concluded an interoperability arrangement) on a near-to-real-time basis.583 The liquidity risk control regime is designed to ensure that the CCP has access at all times to adequate liquidity to perform its services and activities, including with respect to credit lines (Article 44584). Supporting risk-management rules apply in relation to the CCP’s investment policy (which are designed to ensure, inter alia, that a CCP invests its financial resources only in highly liquid financial instruments with minimal market and credit risk, and that a CCP’s investments can be liquidated rapidly and with minimal adverse price effect, and that secure deposit arrangements are used by the CCP for its financial (p. 612) instruments and cash deposits)585 and to settlement.586 CCPs are, more generally, required to regularly review and stress-test (including by means of back testing and in relation to ‘extreme but plausible’ market conditions) their risk-management models and the parameters used for, inter alia, margin calculations, default contributions, collateral requirements, and other risk control mechanisms (Article 49.587)588 Given the obligation on CCPs to continually review and update financial resources and risk-management processes, EMIR seeks to ensure they have timely access to pricing information. The assessment as to whether to subject a class of OTC derivatives to the CCP clearing obligation, for example, includes an assessment as to the availability of fair, reliable, and generally accepted pricing information in the relevant class.589

A specific prudential regime applies to CCP interoperability arrangements, which currently apply only to cash securities; this regime is designed to support interconnectivity between CCPs and thus the EU’s related wider financial market integration agenda, although there is some industry scepticism as to the feasibility of large-scale CCP interconnectivity, given that OTC derivatives CCP clearing is at an embryonic stage.590 Interoperability arrangements, which must be approved in advance by the NCAs of the CCPs concerned (following the procedures which govern the authorization of EU-established CCPs), are subject to particular risk management arrangements (Article 52) and margin requirements (Article 53).591

EMIR is likely to be buttressed by a specific recovery and resolution regime for CCPs. The extent to which CCPs concentrate risk and can generate systemic risk is underlined by the close focus on CCP resolution in the Commission’s 2012 consultation on non-bank recovery and resolution. The Consultation highlights the ‘daunting scenario of the failure of a financial market infrastructure’ and the systemic consequences which could flow from default by a major CCP member in stressed market conditions.592 While it acknowledges the regulatory supports provided by EMIR and the ex ante risk-management procedures now in place, it highlights the need for an orderly recovery and resolution process which (p. 613) protects the tax-payer from fiscal risk in the event of a default, and considers the different elements of a recovery and resolution model.593

VI.4.2.11  CCP Supervision and Cross-border Co-ordination

The supervision of CCPs is broadly the responsibility of the NCA of the Member State within which the CCP is established, although NCAs across the EU have co-ordination and co-operation powers under the 2012 EMIR and each Member State must accordingly designate an NCA for the purposes of EMIR.594 EMIR does not follow the enhanced approach to supervisory and enforcement powers in other crisis-era measures, and simply requires that the NCA have the supervisory and investigatory powers necessary for the exercise of its functions and that the Member States ensure that the appropriate administrative measures (which must be effective, proportionate, and dissuasive) can be taken or imposed against natural or legal persons responsible for non-compliance under EMIR (Article 22). Reflecting the emphasis across EMIR on supervisory review and monitoring of CCP resilience, NCAs (without prejudice to the functions conferred on the CCP college) are subject to a specific review obligation: NCAs must review the arrangements, strategies, processes, and mechanisms implemented by CCPs to comply with EMIR and evaluate the risks to which CCPs are exposed (Article 21).595

The standard co-operation obligations apply, in that NCAs must co-operate closely with each other and with ESMA, but with the addition of the ESCB, reflecting the potential for systemic risk (Article 23). EMIR also specifies that NCAs, in the exercise of their general duties, duly consider the potential impact of their decisions on the stability of the financial system in all other Member States concerned, in particular in Article 24 emergency situations. Where an emergency situation (undefined, but including developments in financial markets which may have an adverse effect on market liquidity and on the stability of the financial system in any of the Member States where the CCP or one of its clearing members are established) arises relating to a CCP, the CCP’s NCA or any other NCA must inform ESMA, the college, the relevant members of the ESCB, and other relevant authorities of the situation without undue delay (Article 24).

CCP colleges are charged with specific co-ordination and co-operation responsibilities under EMIR, notably in relation to authorization, but are also conferred with a series of more general powers with respect to information exchange, the voluntary allocation of tasks between college members, the co-ordination of supervisory examination programmes, and the determination of procedures and contingency plans in relation to Article 24 emergency situations (Article 18(4)). NCAs which are not members of a college may request from the college any information relevant for the performance of their supervisory duties (Article 18(3)).

(p. 614) Co-operation and co-ordination under EMIR is largely a function of the CCP college, although ESMA is also charged with co-ordination between NCAs and across colleges with a view to building a common supervisory culture and consistent supervisory practices; to this end, ESMA must, at least annually, conduct a peer review of the supervisory activities of all NCAs in relation to CCP authorization and supervision, and initiate and co-ordinate EU-wide assessments of the resilience of CCPs to adverse market developments (Article 21(6)).

VI.4.2.12  The Trade Repository Regime

The trade repositories which will hold the massive volume of reporting data required under the 2012 EMIR Article 9 (and which will hold other mandated reports under other EU measures) are subject to a registration and regulation regime which is based on ESMA registration and supervision of trade repositories.596 The regime is closely based on the credit rating agency regime which provided the operational template for ESMA supervision.

The Article 9 reporting obligation requires counterparties and CCPs within its scope to report the required data to a trade repository registered or (in the case of third country trade repositories) recognized under EMIR. To be eligible for ESMA registration, a trade repository must be established in the EU and meet EMIR’s requirements for trade repositories; once registered, a trade repository must comply at all times with the conditions for registration. Registration is effective for the EU (Article 55). The registration process (Articles 56–59 and related BTSs) is based on the rating agency template and requires ESMA to assess the application of the trade repository and to consult (and exchange information) with the relevant NCA where the trade repository is an entity authorized or registered by an NCA in the Member State where it is established. Once registered, trade repositories become subject to a range of ESMA supervisory and enforcement powers, which follow the rating agency model and which empower ESMA to, inter alia, request information, carry out investigations and on-site inspections, take a range of supervisory measures, and impose fines (Articles 60–74). The operational procedural devices and third party protection mechanisms developed under the rating agency regime apply, and so include, inter alia, ESMA’s power to delegate tasks to NCAs, the requirement for supervisory measures and penalty decisions to be assessed by an independent investigation officer within ESMA, and the specification of the particular breaches of EMIR which are subject to particular supervisory measures and penalties.

Once registered, trade repositories become subject to EMIR’s requirements. Chief among these are data transparency and access requirements. Trade repositories must calculate positions, by class of derivative and by reporting entity (Article 80(4)); publish specified aggregated position information; and ensure that identified regulatory authorities and (p. 615) public authorities have direct and immediate access to their data (Article 81).597 Trade repositories are also subject to a relatively standard array of operational requirements, including with respect to governance, organizational structure, internal control mechanisms, conflict-of-interest requirements, compliance procedures, business continuity requirements, the separation of functions (where a trade repository provides ancillary services such as trade matching, credit event servicing, and portfolio reconciliation and portfolio compression services), and ‘fit and proper’ requirements for senior management and board members (Article 78). Like CCPs, trade repositories are also subject to access and related non-discrimination requirements. The strong economies of scale associated with trade repository services have been associated with likely limited competition in this business sector and with a need for related access rules.598 In particular, a trade repository must have objective, non-discriminatory, and publicly disclosed access requirements. The repository must also grant service providers non-discriminatory access to the information held by the repository, as long as the relevant counterparties have consented. Criteria that restrict access are permitted only to the extent that their objective is to control risk to the data maintained by the trade repository (Article 78). Similarly, trade repositories must also publicly disclose the prices and fees associated with the EMIR services provided (these prices and fees must be cost-related) (Article 78). The regulatory regime is calibrated to the particular risks to which trade repositories are vulnerable, including by means of discrete rules governing operational reliability and disaster recovery (Article 79) and the safeguarding and recording of information (Article 80).

VI.4.2.13  Third Countries

The G20 OTC derivatives market reform agenda, of which the 2012 EMIR forms a part, has a global reach and is supported by a swathe of international standards, as well as by ongoing FSB monitoring. But it has generated complex extraterritorial effects, tensions, and risks, related to how jurisdictions, including the EU, address the cross-border reach of their new rules and deploy related recognition and equivalence mechanisms.599

In developing EMIR, the EU frequently adverted to the importance of international convergence.600 In particular, ESMA’s development of the massive EMIR administrative rulebook drew on intensive discussions with third country authorities as well as on the swathe of international principles, reports, and templates available (and in relation to which (p. 616) the Commission was engaged601) in order to reflect and preserve the global nature of the OTC derivatives market and to ensure the ‘global compatibility’ of the EU regime.602 In another example, the development of the BTSs on the margin and capital requirements to be adopted as risk mitigation mechanisms for non-CCP cleared OTC derivatives (Article 11(3) and (4)) was postponed pending international agreement on the standards to be applied. Similarly, the postponement of the adoption of BTSs on how EMIR would apply in relation to OTC contracts with a ‘direct, substantial and foreseeable effect’ within the EU (Article 4(1)) reflected the concern to take into account ongoing discussion with third country authorities on the cross-border application of their rules.603 At the legislative level, particular EMIR provisions also reflect a concern to support global convergence; the decision not to exempt non-financial counterparties fully, for example, was in part driven by the earlier decision by the US not to exempt these actors fully.604

Conversely, EMIR negotiations were complicated by US efforts to shape EMIR to the US 2010 Dodd-Frank Act model,605 reflecting the reality that international co-ordination of OTC derivatives market reforms has proved to be slow and elusive.606 Overall, the adoption of national rules more stringent than those contained in relevant international standards, ‘first mover’ and competitive dynamics, and time-lags between the development of the different regimes internationally have all complicated convergence. Above all, the extraterritorial reach of the new CCP clearing regimes proved problematic globally,607 as it became clear that market actors could become subject to duplicative regimes and be exposed to related costs and legal uncertainties.608 Particular difficulties arose in relation to the extent of the CCP clearing obligation and with respect to whether jurisdictions required national registration and regulation of actors operating in the cross-border OTC derivatives markets, or relied on recognition and/or equivalence (or ‘substitute compliance’) mechanisms to, in effect, dis-apply national rules and allow reliance on the relevant third country regime. Difficulties also arose in relation to risk mitigation standards for non-CCP-cleared transactions, in particular in relation to the quality and quantity of margin.609 A November 2012 meeting of the major international regulators involved sought to generate some degree (p. 617) of consensus.610 Despite the November 2012 efforts, significant international tensions were generated by the registration-based approach adopted by the US in relation to derivatives activities by financial counterparties,611 which led to a co-ordinated call in April 2013 for a more facilitative, equivalence/substitute-compliance-based model,612 a subsequent warning from the G20 for the reforms to be adopted by summer 2013, and some progress.613 While further progress was made,614 the difficulties remained considerable615 and were acknowledged during the 2013/14 negotiations on the EU–US Transatlantic Trade and Investment Partnership.616 Agreement was finally reached by the EU and US in February 2014.617

The EU’s approach has been to apply EMIR expansively, particularly with respect to CCPs and trade repositories, but to support international access through equivalence-based and other mitigation-related mechanisms. The intensity of the EMIR regime, however, has led to the equivalence assessment becoming a lightning rod for tensions related to EMIR’s application.

(p. 618) As outlined in section 4.2.4, the clearing, reporting, and risk mitigation rules apply where one party to a derivative contract is established outside the EU, and can apply where both parties are established outside the EU; there is accordingly significant potential for extraterritorial overreach, and for costs and uncertainty risks relating to duplicating and conflicting rules. A remedial mechanism is contained in Article 13 which empowers the Commission to adopt an equivalence decision providing that a third country’s legal, supervisory, and enforcement arrangements are equivalent to Articles 4 (clearing), 9 (reporting), 10 (application to non-financial counterparties), and 11 (risk mitigation), and are being effectively applied and enforced in an equitable and non-distortive manner so as to ensure effective supervision and enforcement in that third country. Where such a determination has been made by the Commission, the counterparties to the transactions are deemed to have fulfilled the requirements as long as at least one of the counterparties is established in the third country.618

Equivalence mechanisms also govern EMIR’s third country access regime. Third country CCPs which seek access to the EU market are not subject to EMIR directly, but must meet EMIR’s equivalence requirements which apply through the ESMA ‘recognition’ mechanism; the sensitivity of the CCP access rules is implicit in EMIR’s concession that recognition is not required where a third country CCP provides services to EU-established clients through a clearing member established in a third country.619 Otherwise, CCPs established in a third country may provide clearing services to clearing members or to trading venues established in the EU only where the CCP is recognized by ESMA (Article 25). The credit rating agency regime’s third country recognition model has, accordingly, been transplanted to the CCP sphere, albeit with the significant difference that, by contrast with the supervision of rating agencies, NCAs remain responsible for CCP supervision. ESMA’s power in this area, given the centrality of CCPs to financial stability, was contested over the negotiations; early versions conferred third country CCP recognition on NCAs. It was only transferred to ESMA after significant industry opposition based on the potential for divergences across the Member States, and related costs and barriers to international access.620

ESMA may recognize a CCP (which has applied for recognition) when a series of equivalence-, market access/reciprocity-, and co-operation-based conditions are met (Article 25(2)).621 Central to the recognition regime is the equivalence determination. The Commission must have adopted an equivalence decision determining that the legal and supervisory arrangements of the third country ensure that CCPs authorized in that country comply with legally binding requirements equivalent to EMIR’s CCP requirements622 and are subject to effective supervision and enforcement, and that the third country’s legal (p. 619) system provides for an effective, equivalent system for the recognition of CCPs authorized under other third country legal regimes.623

The particular CCP must also be authorized in the relevant third country and, in ESMA’s judgment, must be subject to effective supervision and enforcement, ensuring full compliance with the third country’s prudential requirements;624 an attenuated form of equivalence assessment is accordingly required of ESMA625 which is additional to the full third country equivalence assessment carried out by the Commission and which has, accordingly, generated some market concern.626 Appropriate co-operation arrangements must also have been established.627 Finally, the third country must be considered as having equivalent systems for anti-money-laundering action and combating the financing of terrorism to the EU.

Mirroring the CCP authorization regime, which requires extensive pan-EU co-ordination before an authorization decision is made, ESMA must consult with a range of authorities before the recognition decision is made (Article 25(3));628 ESMA is not, however, subject to veto by other authorities or required to explain where its recognition decision is not in accordance with the views of those consulted. The pan-EU oversight of the third country CCP rests with ESMA.

The trade repository regime for third countries is also governed by ESMA; a trade repository established in a third country may provide services and activities to entities established in the EU only after it has been recognized by ESMA (Article 77(1)). Recognition is conditional on the trade repository submitting to ESMA all the necessary information, including at least the information necessary to verify that the trade repository is authorized and subject to effective supervision in a third country which has been recognized by the Commission as having an equivalent and enforceable regulatory and (p. 620) supervisory framework (Article 77(2)). The Commission’s equivalence decision must positively determine that the legal and supervisory arrangements of the third country ensure that trade repositories authorized in that country comply with legally binding arrangements equivalent to those under EMIR, that effective supervision and enforcement of trade repositories takes place in the third country, and that guarantees of professional secrecy are in place. Reflecting concern as to adequacy of access to trade repository data internationally, the third country must also have entered into an international agreement with the EU which (Articles 77(2) and 75(2)) governs mutual access to and exchange of information on derivative contracts held in trade repositories established in the third country, and which ensures that the EU authorities, including ESMA, have immediate and continuous access to all the information needed for the exercise of their duties. Finally, recognition is conditional on the third country having entered into a co-operation arrangement which ensures that EU authorities, including ESMA, have immediate and continuous access to all necessary information and which governs, at least, information exchange and procedures concerning the co-ordination of supervisory activities (Articles 77(2) and 75(3)). The concern to ensure access to trade repository data internationally is also evident in the Article 76 co-operation mechanism, which provides that where the relevant authorities in a third country do not have any trade repositories established in their jurisdiction (and so fall outside the Articles 75 and 77 co-operation arrangements), they may contact ESMA with a view to establishing co-operation arrangements with ESMA regarding access to information held in EU trade repositories.

Equivalence is accordingly the means by which the reach of EMIR internationally is determined. ESMA, which was charged with providing the Commission with an assessment of the equivalence of relevant third countries, has described its approach as outcome- rather than rules-based, and highlighted its concern to adopt solutions which avoid potential market disruptions. It has proved to be robust in its approach.629

(p. 621) VI.4.2.14  ESMA and the 2012 EMIR

ESMA has had, and will have, a determinative influence on the 2012 EMIR rulebook, on the nature of CCP clearing in the EU, and on the regulation and supervision of the new clearing environment; EMIR engages all of ESMA’s major powers, whether with respect to BTS development, direct supervision, mediation between NCAs, the support of supervisory convergence, college co-ordination, or international co-ordination and engagement.

EMIR represented the first major test of ESMA’s capacity for delivering complex technical standards, and for related engagement with the industry, EU institutions, and international bodies; while the 2011 AIFMD regime imposed similar demands, the Commission retained significantly greater control, reflecting the reliance on administrative rules, rather than on BTSs, for the construction of the AIFMD rulebook. While it sustained some bruises over the EMIR BTS process (section 4.2.3), overall ESMA emerged from the EMIR BTS process as a robust but pragmatic standard-setter, able to manage complex institutional dynamics within the EU and to engage with highly technical rule-making. ESMA has been conferred with specific powers in relation to the future development of the EMIR rulebook, notably in relation to the pension exemption (Article 85), but its determination to continue to shape the EMIR rulebook through own-initiative guidance and Q&As in support of supervisory convergence also suggests a considerable commitment to retaining some control over the EMIR rulebook.

EMIR has also conferred on ESMA highly significant powers in relation to the future shape of OTC derivatives clearing in the EU. It is charged with the determination of the derivatives subject to clearing, whether through the ‘bottom-up’ or ‘top-down’ procedure (Article 5). Although non-voting, it plays a key role in CCP supervisory colleges—particularly where conflicts arise between the home NCA and the college in relation to the authorization of a CCP (Articles 17–19).630 It is charged with the recognition of third country CCPs (Article 25) and the supervision of EU trade repositories (and with related enforcement responsibilities where rules are breached) (Articles 55–74) and the recognition of third country trade repositories (Articles 75 and 77). It will also sit at the centre of a web of information on the OTC derivatives market in the EU, including by means of the data collection required for the new public register (Article 6), the notifications which must be made to ESMA in relation to reliance on the intra-group exemption (Article 11(11)), its access rights in relation to trade repositories (Article 81(3)), and its obligation to receive Article 9 reports where a trade repository is not available (Article 9(3)).

ESMA’s international responsibilities extend beyond its CCP and trade repository recognition role and include the adoption of related co-operation agreements with third countries (Article 25(7), CCPs; Article 75(3), trade repositories) and the establishment of co-operation arrangements concerning access to EU trade repository data with third countries which do not have trade repositories, in order to ease international access to OTC (p. 622) derivatives market data (Article 76). It has also played a key role in negotiations with international authorities on the extraterritorial application of the EU regime internationally and on third country market access by EU market participants.631

EMIR may accordingly significantly enhance ESMA’s capacity as a financial market regulator; however, it also poses material challenges to ESMA. Certain of its powers, notably the determination of the scope of the clearing obligation, will have significant market impact and are likely to strengthen ESMA’s capacity. But ESMA’s highly sensitive role in CCP colleges, given the background fiscal risks, and particularly given tensions between the euro area and the wider internal market—which are unlikely to dissipate as Banking Union develops—will expose the extent to which it can build consensus between NCAs in potentially highly sensitive situations; it will likely have wider ramifications in terms of a consequent strengthening (or weakening) of ESMA’s role vis-à-vis its constituent NCAs. Relations with the Commission are also delicate, given the reach and sensitivity of the EMIR legislative regime; certainly, the autumn 2013 disagreement between ESMA and the Commission on the application of the Article 9 reporting regime suggests some tensions between the Commission and ESMA with respect to ESMA’s BTS powers.632 Overall, the nature of ESMA’s engagement with EMIR may become a useful bellwether for its future development.

VI.4.3  Derivatives Trading on Organized Venues: 2014 MiFIR

As noted in Chapter V, regulators have long outsourced elements of financial market regulation to major trading venues.633 But a more ambitious approach to trading venues developed over the crisis era; trading venues were pressed into action as devices for managing the gaps which arise when financial innovation moves ahead of market infrastructure. This policy agenda is particularly marked with respect to OTC derivatives.

The G20 crisis-era reform agenda for OTC derivatives includes, in addition to the CCP clearing reform, a commitment that trading of standardized OTC derivatives move to ‘exchanges’ or ‘electronic trading platforms’;634 like the CCP clearing reform, it is being supported internationally by the FSB and IOSCO.635 Also like the CCP clearing reform, the trading venue reform has radical market-shaping effects, as most derivatives have typically traded OTC, given their customized quality and the related thin liquidity and limited secondary market trading.636 The trading venue reform is designed to operate in parallel with the CCP clearing reform and to move trading in standardized derivatives, which are sufficiently liquid to support organized venue-based trading, to trading venues (p. 623) which are embedded within wider regulatory regimes governing their stability and efficiency. Greater transparency, ease of regulatory monitoring, operational and risk-management efficiencies, and liquidity enhancements should accordingly follow.637 Mandatory venue trading should also generate competition between organized venues and reduce spreads. Like the CCP clearing reform, this reform is targeted to particular OTC derivatives; it applies only to those derivatives which can be safely traded on organized venues. The reform is accordingly characterized by the imposition of conditions on the classes of derivatives which are subject to the trading venue obligation (predominantly related to the degree of standardization and liquidity levels).638 But the case for mandatory trading is not as straightforward (in relative terms) as the case for mandatory CCP clearing. OTC derivatives trading provides an important function given the generally thin liquidity in derivatives trading markets, and can be regarded as complementary to organized venue trading.639

In the EU, this major reform has proved relatively uncontroversial,640 although it was resisted by the industry.641 The regulatory supports for the reform are set out in the 2014 MiFIR (Articles 28–34) and are based on the regulatory technology developed for the 2012 EMIR; the MiFID II/MiFIR regime is designed to be closely aligned with EMIR. The trading obligation is also closely related to the wider MiFID II/MiFIR trading venue reforms. In particular, the new MiFID II/MiFIR OTF classification is largely designed to provide a regulatory classification and framework for the very wide range of trading venues on which derivatives have previously traded,642 to ensure that organized trading venues for derivatives trading meet appropriate standards,643 and to respond to the particular risks which trading venue regulation poses given the structure of trading in derivatives, and particularly the reliance on dealers (see further Chapter V sections 6.4 and 9 on the OTF).

The new trading venue obligation applies to 2012 EMIR financial counterparties, as well as the non-financial counterparties which come within the scope of EMIR (under EMIR Article 10(1)(b)). These parties must conclude transactions (which do not qualify for the EMIR intra-group transactions exemption, or for transitional exemptions from EMIR) (p. 624) with other financial counterparties or with non-financial counterparties, in relation to a class of derivatives that has been declared to be subject to the trading obligation (and listed in the required ESMA register of such derivatives), only on regulated markets, MTFs, and OTFs (together, MiFIR/MiFID II trading venues) or on third country trading venues, as long as the Commission has made an equivalence determination in relation to the third country (governed by Article 28(4)),644 and as long as that third country provides for an effective equivalent system for the recognition of trading venues authorized under MiFID II to admit to trading or trade derivatives declared subject to the trading obligation in that third country on a non-exclusive basis (Article 28(1) (discussed further later in this section).

Derivatives can therefore be traded on a very wide range of trading venues, and different market structures can be accommodated. The 2014 MiFID II/MiFIR OTF venue, in particular, is designed to accommodate the distinctive nature of derivatives trading, which is typically thin in the secondary markets, and which often takes place on venues operating under a discretionary, dealer-driven quote model. Derivatives trading venues are also highly sensitive to transparency requirements; dealers provide liquidity to the market and take on related capital risk, but need to protect their proprietary positions as a result. As discussed in Chapter V, calibrated operational requirements (with respect to the exercise of discretion in the OTF) and transparency requirements (in relation to non-equity asset classes) apply as a result to mitigate the risks from the new regulatory regime that are faced by derivatives trading platforms.

As is the case for the determination of the derivatives subject to the 2012 EMIR CCP clearing obligation, the critical determination of the classes subject to the trading venue obligation is to be made by ESMA. Also similarly, the ESMA determination has a ‘bottom-up’ dimension, being based in part on whether the derivatives are already admitted to trading. The procedure for determining which classes of derivative are subject to the trading obligation (Article 32) is based on ESMA developing draft RTSs to determine which of the classes of derivatives (subject to the EMIR CCP clearing obligation), or a relevant subset thereof, is to be traded on 2014 MiFIR/MiFID II trading venues, and the date from which the obligation is to take effect (including any phase-in arrangements) (Article 32(1)).645 ESMA is required to conduct a public consultation and, where appropriate, may consult with third country authorities before submitting draft RTSs to the Commission.

For the obligation to take effect, two liquidity-related conditions apply: the class of derivatives (or a relevant subset thereof) must be admitted to trading or traded on at least one 2014 MiFIR/MiFID II trading venue, and there must be sufficient third party buying-and-selling interest in the class of derivatives (or subset) so that the class of derivatives is considered ‘sufficiently liquid’ to trade on these venues (Article 32(2)). A class will be determined as ‘sufficiently liquid’ by reference to the average frequency and size of trades over a range of market conditions, having regard to the nature and life cycle of products within the class, the number and type of active market participants (including the ratio of market participants to products/contracts traded in a given product (p. 625) market), and the average size of spreads (Article 32(3)).646 ESMA is also to determine whether the class of derivatives (or subset thereof) is only ‘sufficiently liquid’ in transactions below a certain size. New RTSs are to be adopted whenever there is a material change in the criteria governing the application of the trading obligation (Article 32(5)).

A ‘top-down’ procedure also applies. ESMA (on its own initiative) is to identify and notify the Commission of the classes of derivatives or individual derivative contracts that should be subject to the trading obligation but for which no CCP has been authorized, or which have not been admitted to trading or traded on a 2014 MiFID II/MiFIR venue (Article 32(4)). The Commission may then publish a call for the development of proposals for the trading of these derivatives on MiFID II/MiFIR venues.

Derivatives subject to the trading obligation must be eligible to be admitted to trading or to trade on any 2014 MiFIR/MiFID I trading venue on a non-exclusive and non-discriminatory basis (Article 28(3)).

ESMA is to regularly monitor activity in derivatives which have not been declared subject to the trading obligation in order to identify cases where a particular class of contracts may cause systemic risk and to prevent regulatory arbitrage (Article 28(2)).

Organized venue-traded derivatives become subject to the panoply of rules which apply to instruments traded on 2014 MiFID II/MiFIR venues generally, and which now include the new transparency requirements (Chapter V section 11), as well as the new position management and reporting requirements which apply to venue-traded commodity derivatives (section 2.5). But the risk-management techniques employed to manage the risks of derivative positions have required that these requirements be calibrated. In particular, MiFIR calibrates the trading regime to reflect the portfolio compression risk management technique (Article 31). Portfolio compression involves two or more counterparties wholly or partially terminating some or all of the derivatives submitted by the counterparties for inclusion in the portfolio compression and replacing the terminated derivatives with another derivative, whose combined notional value is less than the combined notional value of the terminated derivatives (Article 2(1)(47)). Where investment firms provide portfolio compression, they are not subject to best execution or the MiFIR transparency requirements, the termination or replacement of component derivatives in the compression is not subject to the trading venue obligation, and the MiFID II position management regime does not apply. Firms must, however, make public the volumes of transactions subject to portfolio compression (and the time they were concluded) and keep accurate records of all portfolio compressions, which must be made available promptly to the relevant NCA or ESMA on request.

The 2014 MiFIR trading venue obligation is tied to the 2012 EMIR CCP clearing obligation (only derivatives subject to the CCP clearing obligation come within the obligation). Accordingly, in parallel, a CCP clearing obligation applies in relation to (p. 626) transactions in derivatives concluded on a regulated market (which are not subject to EMIR):647 the operator of a regulated market must ensure that all such transactions are cleared by a CCP (Article 29(1)).

In a related obligation, CCPs, trading venues, and investment firms which act as clearing members under the 2012 EMIR must have in place effective systems, procedures, and arrangements in relation to cleared derivatives to ensure that transactions in cleared derivatives648 are submitted and accepted for clearing as quickly as is technologically practical using automated systems; the conditions governing these systems will be specified in RTSs (Article 29(2)). Indirect clearing is permissible, as long as these arrangements do not increase counterparty risk and ensure the assets and positions of the counterparty benefit from protections with equivalent effect to the relevant EMIR protection (Article 30).649

Like the 2012 EMIR CCP clearing obligation, the trading venue obligation has wide extraterritorial effects across a number of dimensions, reflecting the global nature of derivatives trading. The trading obligation applies to counterparties transacting in a class of derivatives subject to the trading obligation with third country financial institutions or other entities that would be subject to the EMIR clearing obligation were they established in the EU; similarly, the trading obligation applies to transactions between two such third country institutions or entities, although, as under EMIR, the trading obligation only applies where the contract has a direct, substantial, and foreseeable effect within the EU, or where such an obligation is necessary or appropriate to prevent the evasion of MiFIR (Article 28(2)).650

The trading obligation can be met by trading on non-EU venues, as long as the stringent equivalence requirement is met (Article 28(1)(d)); the combination of the equivalence assessment and the trading obligation has accordingly allowed the EU to export its regulatory approach to trading venues. The equivalence determination is conditional on the Commission finding that the legal and supervisory framework of the third country in question ensures that a trading venue authorized in the third country complies with legally binding requirements which have equivalent effect to the 2014 MiFID II/MiFIR and the EU market abuse regime, and which are subject to effective supervision and enforcement in the third country (Article 28(4)).651 A reciprocity obligation applies in that the third (p. 627) country must also provide an equivalent system for the recognition of MiFID II/MiFIR trading venues to admit to trading or trade derivatives subject to a trading obligation in that third country on a non-exclusive basis. The international reach of the obligation is also evident in the encouragement to ESMA to consult with third country authorities when identifying the classes of derivatives subject to the trading obligation (Article 32).

VI.5  The Financial Transaction Tax

VI.5.1  Evolution of the EU FTT

The anti-speculation agenda which can be traced through much of the EU’s new trading regime is perhaps most apparent in the proposed FTT.652 While not strictly part of EU securities and markets regulation, and forming instead part of the EU’s taxation regime, it nonetheless has significant implications for trading in the EU. It shares with much of the new trading market regime a concern to dampen perceived excessive speculation and socially wasteful trading activities. The FTT regime has in particular been associated with curbing HFT and speculation in the sovereign debt markets. Accordingly, it has attracted similar political and institutional tensions as have attended the more highly contested elements of the new trading regime.

But tensions have been heightened in this area, and the institutional response has been complex, given the distinct treatment of taxation, as opposed to rule harmonization, under the EU Treaties. The Member States in Council can exercise a veto in relation to the FTT (the EU’s competence to act in relation to the harmonization of indirect taxation is conferred under Article 113 TFEU which requires unanimous Council support). The Treaty context, in combination with diametrically opposed views in the Council, led to the FTT creating a significant breach in the internal market-wide nature of financial market governance. The Banking Union project has set the euro area 19 on a closer integration track with respect to financial system regulation than the internal market 28 (Chapter XI section 7). The FTT is exposing a second line of variable integration in that a small group of Member States will, if the FTT is adopted, become more closely integrated, using the Treaty’s closer co-operation mechanism. As discussed in Chapter I, these developments represent a potentially epochal shift in the nature of EU financial market governance generally.

The roots of the FTT, in common use in different forms internationally,653 go back to the 1970s and the oft-discussed Tobin Tax, which was designed to tax foreign exchange transactions and address excessive exchange rate fluctuation and speculation in currency flows. Over the period of the financial crisis, FTT-style taxes and bank levies were canvassed (p. 628) as financial stability mechanisms and also as funding mechanisms; the Pittsburgh September 2009 G20 meeting, for example, called on the IMF to explore how the financial sector might contribute to the cost of financial system repair.

Bank levies to recover the cost of government rescues and to provide resolution funds are now common across the EU, with a number of Member States imposing some form of bank levy.654 Co-ordination and arbitrage risks have led the EU institutions to consider the appropriateness of a pan-EU bank levy.655 But an FTT is associated with much heavier policy lifting and has direct implications for trading. Similar to bank levies, an FTT is a means of yielding revenue from the financial market sector and addressing the costs of recent interventions.656 It is also, however, associated with the curbing of activities which are perceived to be risky, of markets which are perceived to be excessively large, and of profits which are regarded as economic rents.657 The design and implementation risks are considerable.658 So too are the risks of market damage; FTTs have been linked with, inter alia, a reduction in trading volume and liquidity, an increase in spreads, and increases to issuers’ cost of capital.659 Competitiveness risks are acute in the absence of international co-ordination. Any crisis-era international enthusiasm for co-ordinated FTT action soon waned. The IMF’s response to the Pittsburgh G20 meeting did not endorse FTTs, although it suggested that a profit/wage-related Financial Activities Tax might be used to raise revenue,660 and the November 2011 Cannes G20 summit subsequently failed to support a global FTT.

VI.5.2  The Closer Co-operation Mechanism and the FTT

In the EU, the FTT question quickly became entwined with wider political tensions regarding the nature of financial market intervention and the extent to which financial markets should be constrained.

Initially the EU proceeded cautiously, although the political environment rapidly became febrile. As the FTT debate began to gather momentum in 2010, the European Council expressed cautious support for an FTT to be explored, but this was typically in the context of the EU ‘leading the global debate’661 rather than in relation to the merits of such a tax for the EU. The Council was similarly careful at the outset, being predominantly concerned with the co-ordination risks were Member States to adopt unilateral positions.662 The (p. 629) European Parliament, by contrast, robustly supported implementation of an FTT, adopting resolutions calling on the Commission to explore an FTT in 2010 and 2011 and associating an FTT with the curbing of excessive speculation and with burden-sharing by the financial sector.663

The FTT debate was brought to a head in September 2011 with the Commission’s Proposal for an EU FTT to be adopted in 2014,664 which followed a 2010 Consultation that had revealed very significant disagreement on the merits of a pan-EU FTT.665 The widely cast Proposal, which immediately generated widespread industry hostility,666 was designed to meet three objectives: to avoid fragmentation and arbitrage risks; to ensure that financial institutions made a fair contribution to the costs of the crisis (the Commission estimated the tax would yield revenues of up to €57 billion annually); and, with direct implications for trading, to ensure appropriate disincentives for transactions that do not enhance the efficiency of financial markets.667 The new FTT was, accordingly, a complement to the crisis-era regulatory programme. Given the significant risks which taxes of this nature can pose, its design sought to avoid or mitigate the significant costs and risks (which the Impact Assessment had identified) in relation to economic growth generally and to market liquidity. The FTT was, for example, designed to apply broadly across a wide range of financial instruments and transactions, but the primary markets on which capital is raised were excluded from its scope. It provided for an FTT on all financial transactions (essentially transactions, broadly defined,668 in 2014 MiFID II/MiFIR financial instruments—including shares, bonds, derivatives, money-market instruments, UCITS and alternative investment fund units, and structured products), regardless of whether the transaction took place OTC or on a regulated trading venue.669 The territorial scope of application of the FTT was related to a residence principle, and it was to be levied on financial institutions; it applied where at least one party to the transaction was established in a Member State, and where a financial institution670 established in a Member State was a party to the transaction (on its own account or for the account of another person), or was acting in the name of a party to the transaction. The major exclusions included primary market transactions, entity-specific exclusions,671 and, by implication, most household and (p. 630) business financial transactions, including those relating to insurance contracts, mortgage lending, consumer credit, and payment services, as well as currency market spot (non-derivative) transactions. The rate was to be set by the Member States, subject to a minimum of 0.1 per cent for non-derivative transactions and 0.01 per cent for derivative transactions.672

From the outset, and unsurprisingly, given the febrile environment which attended its development,673 the prognosis for a pan-EU harmonized FTT was poor. Empirical studies on the design and potential impact of the FTT were often hostile, with respect to matters including: its likely inability to achieve its objectives; its failure to distinguish between speculative and productive market behaviour; its damaging behavioural and arbitrage-related effects, including in relation to a potential shift from long-term securities market investments to deposits; its potential prejudicial impact on short-term funding sources for banks and so on financial stability; its impact on firms not typically associated with speculative activity, such as pension funds and insurance undertakings, and the related costs to households; its design, including with respect to cascade effects arising from the application of the FTT repeatedly along the transaction chain; and its economic costs, including with respect to increases in the cost of capital (given the higher yield which would likely be demanded by investors to offset the FTT) and the potential movement of business offshore from the EU.674 The scale of the opposition, and the strength of the empirical arguments, drew an unusual and additional suite of studies from the Commission in May 2012, which provided additional explanations of how the FTT would work in practice and which argued that its risks and costs were not of the magnitude suggested by the stakeholder response to the FTT.675

While France and Germany provided strong support from an early stage, and were associated with leading Council discussions and with pushing the EU to provide a global lead,676 the UK was trenchantly opposed.677 The proposed Treaty Financial Services Protocol, for example, which the UK had called for as part of its negotiating position during the December 2011 negotiations on the proposed European Stability Treaty, contained a commitment that any such tax be subject to a Member State veto, reflecting UK concern that the FTT, in principle subject to a Member State veto as a matter of taxation policy, could not be (p. 631) re-characterized as a ‘user charge’ and so be subject to a QMV.678 Council negotiations over 2011–12 saw repeated clashes between Ireland, the Netherlands,679 Sweden, and the UK, in particular, on the one hand, and the Member States in favour of the FTT, notably France,680 Germany, and Spain, on the other.

As the FTT was proposed under Article 113 TFEU and in relation to the EU’s taxation competence, the European Parliament was not a co-legislator in relation to the Proposal, but was consulted. It broadly supported the Commission’s 2011 Proposal,681 but recommended a more stringent approach and significantly extended the reach of the regime, adding an ‘issuance principle’ which would have required financial institutions located outside the FTT ‘zone’ to pay the FTT if they traded securities originally issued within the zone.682 The strong anti-speculation mood in the Parliament which drove its FTT agenda was also evident in its suggestion that a lower rate apply in relation to transactions taking place on a ‘stock exchange’, rather than OTC. Presciently, it also suggested that the enhanced co-operation mechanism be deployed were it not possible for the Member States to reach agreement.

The Commission’s Proposal was abandoned in June 2012 when it became clear that the unanimous Council vote required under Article 113 TFEU to adopt the Proposal could not be achieved; the June 2012 ECOFIN Council concluded that support was not forthcoming for the Commission’s Proposal. By now, however, it was clear that a significant number of Member States wished to proceed under the Treaty ‘enhanced co-operation’ mechanism, although the Council warned that the formal requirements for enhanced co-operation must be met.683

Article 20 TEU and Articles 326–334 TFEU allow Member States to establish ‘enhanced co-operation’ between themselves within the framework of the EU’s non-exclusive competences and to use the EU’s institutions and competences to do so, as long as the related Treaty conditions are met. Under Article 20 TFEU, enhanced co-operation (which must aim to further the objectives of the EU, protect its interests, and reinforce its integration process) must first be approved by the Council ‘as a last resort’ and before the enhanced co-operation measure is adopted; acts adopted within the framework of enhanced co-operation apply only to the participating Member States (Article 20(1), (3), and (4) TEU). The Council (acting unanimously) may only authorize enhanced co-operation where it has established that the objectives of the co-operation cannot be attained within a reasonable period by the EU as a whole and where at least nine Member States participate in the arrangement (Article 20(2) TFEU). Additional conditions apply under Article 326–334 TFEU.684 Following (as required under the Treaties) a request to the Commission from 11 (p. 632) Member States to proceed in relation to the FTT through enhanced co-operation,685 the Commission submitted a proposal for a Council Decision approving enhanced co- operation in October 2011, which proposal set out the Commission’s assessment of the compliance of the proposed arrangement with the Treaty conditions.686 The Commission, which highlighted that its preference was for a pan-EU FTT, concluded that enhanced co-operation on an FTT would support the EU’s objectives and reinforce the integration process.

Following the European Parliament’s consent (required under the Treaty procedures), the proposal for approval was adopted by the Council in January 2013.687 A Commission proposal for an FTT under the enhanced co-operation mechanism (for 11 participating Member States) followed in February 2013.688 The Proposal was, at the request of the participating Member States, heavily based on the original September 2011 model, including with respect to scope, the financial-institution-establishment connecting factor, and rates (it was accordingly not subject to a new Impact Assessment). It contained, nonetheless, a number of revisions—mainly designed to reflect the application of the FTT within the participating Member States’ ‘FTT zone’,689 but also to refine and extend the original FTT model through an issuance principle.690

(p. 633) The wide extraterritorial effect of the new FTT proposal, given in particular the impact of the issuance principle, in combination with the persistence of the features of the FTT which had earlier generated concern,691 generated an avalanche of criticism. Financial and general industry opposition in the EU,692 Member State concern outside the FTT zone (particularly in the UK,693 which in April 2013 launched an unsuccessful challenge to the FTT before the European Court of Justice694) and international hostility695 rapidly became intense, well exemplified by the communication from a group of leading international trade associations to the G20 expressing opposition to the tax.696 The FTT continued, however, to be supported by the European Parliament,697 although the ECB was more circumspect.698 At the time of writing, the future of the FTT is uncertain. Support remains strong from France and Germany, however, and initial agreement was reached on a revised, scaled-back tax in May 2014.699 But its troubled passage underlines the increasing stresses being placed on the single market (as discussed further in Chapter I).


1  See, eg, Amihud, Y and Mendelson, H, ‘Asset Pricing and the Bid Ask Spread’ (1986) 17 JFE 223 and Levine, R, ‘Financial Development and Economic Growth: Views and Agenda’ (1997) 35 J of Econ Lit 685.

2  Markets in Financial Instruments Directive 2004/39/EC [2004] OJ L145/1.

3  Markets in Financial Instruments Directive II 2014/65/EU [2014] OJ L173/349 (2014 MiFID II) and Markets in Financial Instruments Regulation EU (No) 600/2014 [2014] OJ L173/84 (2014 MiFIR). On the implementation timeline see Ch IV n 28. The discussion in this Chapter is based on the 2014 MiFID II/MiFIR (MiFID I will be repealed from 3 July 2017 when the 2014 MiFID II/MiFIR applies). Reference is made to MiFID I as appropriate.

4  For early perspectives see Franks, J and Mayer, C, Risk, Regulation and Investor Protection. The Case of Investment Management (1989) 158 and OECD, Report on Risk Management in Financial Services (1992).

5  Ch IV sect 8.1.

6  Over 2012, JP Morgan Chase sustained some $6.2 billion of losses arising from very large trades in complex synthetic credit derivatives, which were termed the ‘London Whale’ trades given their size and impact on credit markets, and which generated close political attention: eg US Senate, Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs, JP Morgan Chase Whale Traders. A Case History of Derivatives Risks and Abuses (2013). A co-ordinated global settlement with the leading regulators engaged followed under which JP Morgan Chase was fined $920 million (eg SEC (US Securities and Exchange Commission) Press Release 2013 2013-187e_x2013;187, 19 September 2013).

7  In July 2013, and following the opening of the investigation in April 2011, the EU published its ‘Statement of Objections’ relating to its investigation of 13 investment banks, the International Swap Dealers’ Association, and the data services provider Markit, setting out its preliminary finding that these actors had colluded to prevent Deutsche Börse and the Chicago Mercantile Exchange from having access to the licences for data and index benchmarks necessary for them to access the CDS market and to support exchange trading in these instruments: Commission, Press Release 1 July 2013 (IP/13/630). As discussed in sect 4.3, a trading venue trading obligation now applies to certain classes of derivative.

8  eg OECD, Bank Competition and Financial Stability (2011) ch 2.

9  The US led the way with the highly contested ‘Volcker Rule’ (2010 Dodd-Frank Act s 619), which prohibits federally insured depositary institutions and their affiliates (‘banking entities’) from engaging in short-term proprietary trading (market-making and hedging activities are permitted), and from acquiring or retaining any equity, partnership, or other ownership interest in or sponsoring a hedge fund or private equity fund (the final rules were adopted in December 2013 and came into force in April 2014).

The UK reforms, which are less intrusive (they do not ban proprietary trading) but which were similarly contested, are derived from the ‘Vickers Report’ (Independent Commission on Banking, Final Report. Recommendations (2011)), and will lead to a legal ring-fence being erected between, essentially, retail and SME/commercial deposit-taking and lending services, and investment banking services, within major banking groups (2013 Financial Services (Banking Reform) Act). The UK Prudential Regulation Authority is required to review the nature of proprietary trading within in-scope entities; this review will support the required subsequent independent review of whether further restrictions should be placed on proprietary trading. On the development of the UK regime see HM Treasury and Department of Business Innovation and Skills, Banking Reform: Delivering Sustainability and Supporting a Sustainable Economy (2012) and Banking Reform: A New Structure for Stability and Growth (2013). Discussion of these reforms, which are directed to the stability of the banking sector, and of the host of complex issues which arise, including with respect to the scope of the separation/ring-fence, is outside the coverage of this work. See, eg, Schwarcz, S, ‘Ring-Fencing’ (2013) 87 So Cal LR, Skeel, D, The New Financial Deal (2011) 85–93, Boot, A and Ratnovski, L, Banking and Trading, IMF WP No 12/238 (2012), and Chow, J and Surti, J, Making Banks Safer: Can Volcker and Vickers Do It? IMF WP No 11/236 (2011).

10  The Liikanen Group report (High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report (2012)), which followed a Commission mandate, made a series of recommendations on structural reform of the EU banking sector which included capital-, resolution-, and governance-related reforms, and which also included the recommendation that proprietary trading and other significant trading activities (where they represented a significant share of a bank’s business) be assigned to a separate legal entity. See Ojo, M, Volckers/Vickers Hybrid? The Liikanen Report and Justifications for Ring Fencing and Separate Legal Entities (2013), available at <http://ssrn.com/abstract=2211171>.

11  European Parliament, Report on Reforming the Structure of the EU Banking Sector (2013) (2013/2012 (INI)).

12  COM (2014) 43, which followed two Commission consultations: Consultation on the Structural Reform of the Banking Sector (2013) and Consultation on the Recommendations of the High Level Expert Group on the Structure of the EU Banking Sector (2012).

13  Defined in specific terms under the Proposal (Art 5) as using own capital or borrowed money to take positions in any type of transaction to purchase, sell, or otherwise acquire or dispose of any financial instrument or commodities for the sole purpose of making a profit for own account, and without any connection to actual or anticipated client activity or for the purpose of hedging the entity’s risk as a result of actual or anticipated client activity, through the use of desks, units, divisions, or individual traders specifically dedicated to such position taking and profit-making.

14  Although the reform is not projected to require major change within in-scope banking groups, given the global impact of the Volcker Rule on proprietary trading.

15  The Proposal requires that such trading activities be transferred to a distinct legal entity within the group. Separation requirements apply under the Proposal to ensure these entities are effectively separated, such that the group is organized into subgroups composed of core (deposit-taking) credit institutions and trading entities.

16  The metrics include relative size, leverage, complexity, profitability, market risk, and interconnectedness. In certain circumstances and where specified thresholds are passed, the NCA must require separation.

17  The prohibition would apply to any credit institution or an EU parent, including all branches and subsidiaries (including in third countries), where it is identified as a G-SIFI in accordance with the 2013 CRD IV/CRR regime (Directive 2013/36/EU [2013] OJ L176/338 (Capital Requirements Directive (CRD IV)) and Regulation EU No 575/2013 [2013] OJ L176/1 (Capital Requirements Regulation (CRR)): Arts 3 and 6.

18  In this case, the following entities would be covered: any credit institution operating in the EU which is neither a parent nor a subsidiary (including all branches); an EU parent (including all branches and subsidiaries wherever located); and EU branches of credit institutions in third countries: Art 3.

19  The separation regime would apply to a core EU credit institution (one which at a minimum takes deposits) which is neither a parent nor a subsidiary (but including its branches); an EU parent (including all branches and subsidiaries, irrespective of location, as long as one group entity is a core credit institution established in the EU); and EU branches of third country credit institutions: Art 9.

20  eg Barker, A and Fleming, S, ‘EU Banking Plan Raises Anxiety’, Financial Times, 30 January 2014, 6, characterizing the Proposal as cautious, and as steering a careful route across current Member State proposals, but reporting on significant industry anxiety. The 2014 Commission Proposal is in some respects weaker than the 2012 Liikanen Report, particularly with respect to the discretionary model applied to separation, but is tougher with respect to the prohibition on proprietary trading.

21  Exemptions are available for third country branches and subsidiaries of EU credit institutions, and for EU branches of third country banks, as long as an equivalent regime applies.

22  The European Parliament’s suspicion of trading in derivatives is indicative of this agenda: European Parliament, Resolution on Derivatives Markets: Future Policy Actions, 15 June 2010 (P7_TA(2010)0206), calling on the Commission to look into ways of significantly reducing the overall volume of derivatives so that the volume is proportionate to the underlying securities: para 9.

23  Hill, J, ‘Why did Australia Fare so Well in the Global Financial Crisis’ in Ferran, E, Moloney, N, Hill, J, and Coffee, J, The Regulatory Aftermath of the Global Financial Crisis (2012) 203, 256. For an example of an anti-speculation analysis see Finance Watch, Investing not Betting. Making Financial Markets Serve Society (2012).

24  On the policy suspicion of financial innovation and financial market intensity which emerged over the crisis era, and the related anti-speculation movement, see further Ch I and Moloney, N, ‘The Legacy Effects of the Global Financial Crisis on Regulatory Design in the EU’ in Ferran et al, n 23, 111.

25  UK Financial Services Authority (FSA), The Turner Review. A Regulatory Response to the Global Financial Crisis (2009) 41–2.

26  Authorité des Marchés Financiers (AMF), What are the Priorities for Financial Markets? (2011).

27  The 2013 Green Paper on Long-Term Financing, eg, notes the EU policy concern to reduce short-term and speculative trading activities and to improve investor protection: Commission, Green Paper on Long-Term Financing of the European Economy (2013) (COM (2013) 150) 11.

28  See, eg, the Parliament’s Resolution on innovative trading practices which supports measures to curb excessive short-termism and speculation: European Parliament, Resolution on Innovative Financing at a Global and European Level, 8 March 2011 (P7_TA(2011)0080).

29  The algorithmic trading reforms also relate to the G20 agenda. The Seoul Action Plan adopted at the November 2010 Seoul G20 Summit, and in response to a French initiative, added measures to improve market efficiency and integrity to the previously stability-dominated G20 agenda: Seoul G20 Summit, November 2010, Leaders’ Declaration, paras 11 and 41. The International Organization of Securities Commissions (IOSCO) responded with, inter alia, its 2011 Report on Regulatory Issues raised by the Impact of Technological Changes on Market Integrity and Efficiency, which addresses algorithmic trading.

30  eg O’Hara, M, Liquidity and Financial Market Stability, National Bank of Belgium WP No 55 (2004), available at <http://ssrn.com/abstract=1691574>.

31  eg O’Hara, n 30, highlighting the debate on the ‘dark side of liquidity’ and its leading proponents, including Keynes in the 1930s and Tobin in the 1970s.

32  For a policy perspective see, eg, Committee on the Global Financial System, Paper No 45, Global Liquidity—Concept, Measurement and Policy Implications (2011).

33  Regulation (EU) No 236/2012 [2012] OJ L86/1.

34  Regulation (EU) No 648/2012 [2012] OJ L201/1.

35  Directive 2013/50/EU [2013] OJ L294/13.

36  Inevitably, there is some overlap between the coverage of both Chapters. The trading transparency rules discussed in Ch V include, eg, the transparency rules which govern bilateral trades away from organized venues in the OTC markets.

37  Dealing on own account covers a range of practices, including market-making and proprietary dealing.

38  See Ch IV sect 4.3 on in-scope financial instruments.

39  On the MiFID II and MiFIR negotiations generally see Ch IV sect 2.3.3 (MiFID II) and Ch V sect 3 (MiFID II/MiFIR).

40  2011 MiFID II Proposal (COM (2011) 656/4) 7.

41  See sect 2.3 on the definition of high frequency trading.

42  The earlier MiFID I exemption (Art 2(1)(k)) for persons whose main business consisted of dealing on own account in commodities and/or commodities derivatives has been removed, reflecting the tightening of regulation over commodity derivatives generally (sect 2.5).

43  n 17.

44  On the classification of eligible counterparties, professional clients, and retail clients see Ch IV sect 5.2.

45  These requirements are dis-applied from trades between eligible counterparties.

46  See generally, FSA, Discussion Paper 06/3, Implementing MiFID’s Best Execution Requirements (2006) and Macey, J and O’Hara, M, ‘The Law and Economics of Best Execution’ (1997) 6 J Fin Intermed 193.

47  The pre-MiFID I obligation in most Member States was, typically, simply to match the prevailing price on the local regulated market. The UK’s regime was regarded as being considerably more advanced than those of other Member States: Report, ‘Could Brussels Drive Share Trading out of Europe?’ (2003) 22 IFLR 17, 22.

48  See generally Ferrarini, G, ‘Best Execution and Competition Between Trading Venues—MiFID’s Likely Impact’ (2007) 2 CMLJ 404.

49  The Commission described the MiFID I best execution regime as ‘central to the structure and logic of the Directive. [Best execution obligations] not only form a fundamental element of investor protection, but are also necessary to mitigate possible problems associated with market fragmentation’: Commission, Background Note to the Draft Commission Directive, February 2006, 24.

50  Ferrarini, G, ‘Contract Standards and the Markets in Financial Instruments Directive’ (2005) 1 Euro Rev Contract L 19, 38.

51  Ferrarini, n 48, 407.

52  Directive 2006/73/EC [2006] OJ L241/26.

53  Working Document ESC/07/2007, Commission Answers to CESR Scope Issues under MiFID and the Implementing Directive.

54  CESR, Best Execution under MiFID. Questions and Answers (2007) (CESR/07-320). Of particular note is CESR’s approach to the controversial question of whether a firm could include only one execution venue in its policy. CESR suggested that MiFID I did not prohibit firms from selecting only one venue (as long as the choice could be justified as obtaining the best possible result on a consistent basis), and that circumstances could arise where a particular venue would consistently achieve the best possible result, or where the costs of including more than one venue would outweigh any price improvement.

55  See further Ch V on the impact of MiFID I on trading.

56  The Proposal applied a ‘reasonable’ standard (supported by the Council) but the European Parliament inserted a higher ‘necessary’ standard: MiFID II, Parliament Negotiating Position, 28 October 2012 (P7_TA (2012)0406) Art 27(1). ‘Sufficient’ was the compromise solution.

57  This obligation requires shares admitted to a regulated market to be traded on certain classes of trading venue only, and imposes a trading venue obligation on particular derivatives (Ch V sect 6.6 and this Ch sect 4.3).

58  A systematic internalizer is an investment firm which systematically executes client orders internally through bilateral dealing: Ch V sect 6.5.

59  The Commission noted that data relating to, eg, speed of execution and number of orders cancelled prior to execution was relevant to the assessment of best execution: 2011 MiFID II Proposal (COM (2011) 656/4) 8. This reform received strong support from the Member States and from the buy-side: 2011 MIFID II/MiFIR Proposals Impact Assessment (SEC (2011) 1226) 55.

60  On MiFID II/MiFIR trading venues see Ch V. The earlier and similar MiFID I consent requirement was described as creating a hierarchy among trading venues and as unnecessary for investor protection: Köndgen, J and Theissen, E, ‘Internalization under the MiFID: Regulatory Overreaching or Landmark in Investor Protection’, in Ferrarini, G and Wymeersch, E (eds), Investor Protection in Europe. Corporate Law-Making, The MiFiD, and Beyond (2006), 271, 287.

61  The Commission acknowledged that where the costs of connecting to certain execution venues would be disproportionate and lead to a heavy overall increase in fees, firms would not be expected to connect to such venues: Background Note, n 49, 25. CESR’s approach was also facilitative (n 54).

62  The lifting of the direct best execution obligation was the result of concerted lobbying by the investment management industry: Stones, R, ‘An Introduction to MiFID and its Controversies’ (2006) 25(8) IFLR 22.

63  Working Document ESC/07/2007, Commission Answers to CESR Scope Issues under MiFID and the Implementing Directive (2007).

64  Ferrarini, G and Recine, F, ‘The MiFID and Internalisation’ in Ferrarini and Wymeersch, n 60, 235, 257.

65  The obligation extends to conversations and communications which are intended to result in transactions concluded when dealing on own account and the provision of client order services, even if the communication or conversation does not lead to this outcome. See Ch IV sect 7.2.

66  eg, Justham, A, (UK FSA), Speech on ‘Evolving Market Structures and the Focus on Speed—How Regulators Should try to Keep Pace’, 25 November, 2010.

67  Co-location involves the firm/trader’s servers being located within the trading venue in question. Direct electronic access involves a firm/trader connecting directly to a trading venue through a member or participant firm; such arrangements are termed ‘sponsored access’ where the trader does not place the order through the firm’s trading infrastructure. The MiFID II approach is to term both forms of sponsored and direct access as direct electronic access and to treat both forms in broadly the same manner (MiFID II Art 4(1)(41)). Most EU HFT activity is in the form of co-location.

68  See further Hagströmer, B and Nordén, L, The Diversity of High Frequency Traders (2012), available at <http://ssrn.com/abstract=2153272>.

69  Estimates of its scale vary. It has been estimated as accounting for in the region of 30–50 per cent of trading: FSA, The FSA’s Markets Regulatory Agenda (2010) 18. The European Securities and Markets Authority (ESMA) reported that HFT firms accounted for some 40–70 per cent of total equity trading volume in Quarter 4 2010 in the EU equity market: ESMA, HFT Consultation (2011) (ESMA/2011/224) 49.

More recently, ESMA has reported that HFT firms accounted for some 22 per cent of value traded in EU equity markets in May 2013, and that levels of HFT activity in different trading venues range from 8 per cent to 39 per cent (being higher on multilateral trading facilities (MTFs) (close to 40 per cent) than on regulated markets (close to 20 per cent)). ESMA also found that most orders in EU equity markets (60 per cent) originate from HFT firms (the volume of orders is significantly larger than the number of trades executed (some 22 per cent)): ESMA, Trends, Risks, and Vulnerabilities. Report No 1 (2014) (ESMA/2014/0188) (ESMA 2014(1) TRV), Report on High Frequency Trading Activity in EU Equity Markets (at 41–7).

70  FSA, n 69, 18.

71  eg, and from an extensive literature, Hendershott, T, Jones, C, and Menkveld, A, ‘Does Algorithmic Trading Improve Liquidity’ (2011) 66 J Fin 1 and Jovanovic, B and Menkveld, A, Middlemen in Limit Order Markets (2011), available at <http://ssrn.com/abstract=1624329>, examining the Belgian and Dutch markets.

72  CESR, Impact of MiFID on Equity Secondary Market Functioning (2009) (CESR/09/355) 18.

73  eg, Grob, S, ‘The Fragmentation of the European Equity Markets’ in Lazzari, V (ed), Trends in the European Securities Industry (2011) 127.

74  During a 20-minute period starting at 2:40 pm, over 20,000 trades, across more than 300 securities, were executed at prices which were some 60 per cent away from the 2:40pm prices. While the subsequent SEC/CFTC Report identified a series of causes, it highlighted the impact of an automated ‘Sell Algorithm’ which executed trades in some 75,000 derivative contracts. SEC and CFTC, Findings Regarding the Market Events of May 6 2010 (2010).

75  Hertig, G, ‘MiFID and the Return to Concentration Rules’ in Grundmann, S, Haar, B, Merkt, H, Mülbert, P, and Wellenhofer, M (eds), Festschrift für Klaus Hopt zum 70. Geburtstag am 24 August 2010 (2010) 1989.

76  London Economics, Understanding the Impact of MiFID in the Context of Global and National and Regulatory Innovation (2010).

77  On algorithmic trading generally see the UK government-sponsored study into computer-based/algorithmic trading generally: Foresight, the Future of Computer Trading in Financial Markets. Final Project Report (2012).

78  The UK government’s 2012 Foresight study examined the array of evidence and concluded that while some of the commonly-held negative perceptions of HFT and algorithmic trading were not supported by the evidence, and while these trading practices were associated with improvements to market functioning, policymakers were justified in focusing on these forms of trading, given the potential risks in terms of periodic illiquidity, market instability, and market abuse: n 77. Similarly, a Bank of England study has found that high frequency traders can contribute both ‘good’ and ‘excessive’ volatility and that it is not immediately clear what the welfare implications of HFT are: Benos, E and Sagade, S, High-frequency Trading Behaviour and its Impact on Market Quality, Bank of England WP No 469 (2012). From the price formation perspective, and finding that HFT facilitates efficient price discovery, see Brogaard, J, Hendershott, T, and Riordan, R, High Frequency Trading and Price Discovery, ECB WP Series No 1602 (2013).

79  eg, Angel, J, Harris, L, and Spatt, C, Equity Trading in the 21st Century, Marshall School of Business WP No FBE 09 09-10 (2010), available at <http://ssrn.com/abstract=1584026>.

80  Haldane, A (Bank of England), Speech on ‘The Race to Zero’, 8 July 2011. Internationally, the examination of HFT quickly acquired some momentum, with the US SEC examining issues related to HFT (SEC, Concept Release 34-61358, Concept Release on Equity Market Structure (2010)), and IOSCO, in response to a G20 mandate, addressing automated trading generally (IOSCO, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency. Consultation Report (2011) and earlier, IOSCO, Principles for Direct Electronic Access (2010)).

81  Pre-empting the EU response and reflecting the more sceptical approach to intense levels of market activity in Germany, in February 2013 Germany adopted the High Frequency Trading Act which imposes a licensing requirement on high frequency traders, imposes conduct-of-business and organizational rules on algorithmic trading generally, and identifies how algorithmic trading can amount to market abuse.

82  ESMA, Guidelines on Systems and Controls in an Automated Trading Environment for Trading Platforms, Investment Firms and Competent Authorities (2011) (ESMA/2011/456). ESMA’s Guidelines build on earlier CESR work, including CESR, Microstructural Issues of the European Equity Markets (2010) (CESR/10-142).

83  The trading venue requirements are outlined in Ch V.

84  In its 2011 Resolution on Innovative Financing, the European Parliament highlighted that HFT was associated with excessive price volatility and the persistent deviation of securities and commodity prices from fundamental levels, and linked its control to the highly contested FTT: n 28, para 13 and para D.

85  Council discussions were relatively smooth and generally supportive of the Commission’s approach, with most discussion focusing on the concern of Member States to fine-tune the Commission’s proposal that algorithmic traders provide liquidity on a continuous basis (the regime as adopted limits this obligation to market-making algorithms): Danish Presidency Progress Report on MiFID II/MiFIR, 20 June 2012 (Council Document 11536/12) (Danish Presidency MiFID II/MiFIR Progress Report) 9.

86  The European Parliament called, eg, for minimum resting periods for orders to quell HFT and rules governing the minimum tick size (or minimum price movement increment): 2012 Parliament MiFID II Negotiating Position, n 56, Art 51(1b). These were finally accepted during the trilogue negotiations (Ch V sect 7.3).

87  The 2012 Foresight Report, eg, cautioned against restrictive requirements, including with respect to continuous liquidity provision, minimum order resting times, and order-to-execution ratios.

88  The definition does not include any system used only for the purpose of routing orders to trading venues or for the processing of orders involving no determination of any trading parameters, or for the confirmation of orders or the post-trade processing of executed transactions.

89  High frequency algorithmic trading is defined as any algorithmic trading technique characterized by: infrastructure intended to minimize network and other types of latencies (including at least co-location, proximity hosting, or high speed ‘direct electronic access’ (n 93)); system determination of order initiation, generating, routing, or execution, without human intervention for individual trades or orders; and high message intraday rates which constitute orders, quotes, or cancellations: Art 4(1)(40).

90  Including with respect to trading parameters and limits, testing details, and key compliance and risk controls.

91  A firm pursues a market-making strategy when, as a member or participant of one or more trading venues, its strategy, when dealing on own account, involves posting firm, simultaneous two-way quotes of comparable size, and at competitive prices, relating to one or more financial instruments on a single trading venue or across different trading venues, with the result of providing liquidity on a regular and frequent basis to the overall market: Art 17(4).

92  The Commission’s earlier version of this provision generated intense industry hostility as it required all algorithmic trading strategies to be in continuous operation during the trading hours of the trading venue in question, and did not reflect the limited nature of many algorithms which are not designed to act as liquidity providers and which are not rewarded accordingly: 2011 MiFID II Proposal, n 59, Art 17(3).

93  Defined as an arrangement where a member or participant of a trading venue permits a person to use its trading code so the person can electronically transmit orders relating to a financial instrument directly to the trading venue (whether or not the person in question uses the infrastructure of the member or participant or any connecting system provided by the member or participant): Art 4(1)(41). The regime does not accordingly differentiate between direct and sponsored access.

94  Firms must monitor transactions in order to identify breaches of MiFID II and of the trading venue’s rules, disorderly trading conditions, or conduct that may involve market abuse and that should be reported to the NCA. The firm must also ensure there is a binding written agreement between the firm and the client regarding the essential rights and obligations arising from the provision of the services; the firm must, under the agreement, retain responsibility under MiFID II. Where the firm provides direct electronic access to a trading venue, it must notify this to its home NCA and the trading venue at which the firm provides direct electronic access (the home NCA may require the firm to provide, on a regular or ad hoc basis, a description of the systems and controls used in relation to direct electronic access (this information must be shared with the NCAs of the relevant trading venues when requested)).

95  Art 1(5) (the direct electronic access requirements) does not apply.

96  A market-maker is a person who holds himself out on the financial markets on a continuous basis as being willing to deal on own account by buying and selling financial instruments against his proprietary capital at prices defined by him: Art 4(1)(7).

97  RTSs will amplify the market-making conditions: Art 51(12).

98  An organized trading facility (OTF) is a form of 2014 MiFID II/MiFIR trading venue (Ch V sect 6.4).

99  Between 1998 and 2008, the proportion of trading in commodity derivatives accounted for by physical hedgers fell from 77 per cent to 31 per cent, while the proportion accounted for by traditional and index speculators increased from 16 per cent and 7 per cent to 28 per cent and 41 per cent, respectively: Finance Watch, n 23, 39.

100  eg, from an EU policy perspective, Commission, Public Consultation on the Markets in Financial Instruments Directive Review (2010) 37–9 and 2010 Parliament Resolution on Derivatives Markets, n 22. From the very extensive literature on the impact of derivatives trading on commodity markets and prices see, eg, Nissanke, M, ‘Commodity Market Linkages in the Global Financial Crisis: Excess Volatility and Development Impacts’ (2012) 48 J of Development Studies 732 and Gutierrez, L, ‘Speculative Bubbles in Agricultural Commodity Markets’ (2012) European Rev of Agricultural Economics 1.

101  Pittsburgh G20 Summit, September 2009, Leaders’ Statement, Strengthening the International Financial Regulatory System, para 12. The Communiqué of G20 Finance Ministers and Central Bank Governors of 15 April 2011 similarly called for participants on commodity derivatives markets to be subject to appropriate regulation and supervision, for enhanced transparency in both cash and derivatives markets, and for position management powers (para 15).

102  eg IOSCO, Principles for the Regulation and Supervision of Commodity Derivatives Markets (2011).

103  Commission, Tackling the Challenges in Commodity Markets and Raw Materials (2011) (COM (2011) 25) and Commission, A Better Functioning Food Supply Chain in Europe (2009) (COM (2009) 591).

104  The 2014 position oversight regime applies to persons otherwise exempted under the MiFID II exemption regime: 2014 MiFID II Art 1(6).

105  Commodity derivatives are defined as those financial instruments related to a commodity or underlying mentioned in 2014 MiFID II, Annex I, sect C(10) or within Annex I, sect C(5), (6), (7), and (10) (2014 MiFIR Art 2(1)(3)). On the scope of Annex I see Ch IV sect 4.3.

106  Position limits were strongly resisted by market participants as being arbitrary and as not reducing volatility. They were supported, however, by the EU institutions (albeit with some disagreement as to where the power to set position limits should be located (whether at NCA or trading venue level), and the extent to which limits should be governed by EU rules), and in particular by the European Parliament which saw them as a means for reducing speculation and volatility.

107  The regime evolved significantly over the negotiations. The Commission proposed the position limits power but provided for the Commission to adopt position limits (through administrative rules). The European Parliament took a restrictive approach, which included the capturing of positions designed to reduce risks from commercial activities, through a ‘position check’ system (although such positions are typically excluded from regulation across the EU regulatory regime or subject to careful calibration). The Council’s position was more light-touch. The trilogue negotiations brought significant nuance to the regime, including with respect to a distinction between person-related position limits and contract-related limits, detailed specification of the RTSs which will govern this area, and a co-ordination mechanism for establishing limits, given that trading occurs across different venues.

108  The regulated markets, MTFs, and OTFs within the scope of MiFID II/MIFIR: see Ch V.

109  It is embedded in, eg, the 2012 EMIR regime (sect 4.2) and also applies under MiFID II (eg Ch IV sect 5 on exemptions).

110  The different factors which ESMA is to consider in developing the RTSs are specified in Art 57(3) and include the maturity of the commodity derivative contract; the overall ‘open interest’ in that contract (or the total of all futures and options contracts held) and in other financial instruments with the same underlying commodity; deliverable supply in the underlying commodity; the volatility of the relevant markets (including markets for substitute derivatives and underlying commodity markets); the number and size of market participants; the characteristics of the underlying commodity market; and the development of new contracts. ESMA must also take into account experience with position limits gained by investment firms or market operators operating a trading venue, and in other jurisdictions.

111  On these powers see Ch XI sect 5.3.1.

112  In relation to Art 69(2)(p), the NCA must comply with notification obligations (to the other NCAs and ESMA) and the NCA receiving a notification may take similar action (2014 MiFID II Art 79(5)). ESMA is also conferred with related co-ordination powers, including with respect to collation and publication of all such measures (2014 MiFIR Art 44(2)).

113  Cyprus Presidency Progress Report on MiFID II/MiFIR, 13 December 2012 (Council Document 16523/1212). The nature of the powers to be granted to ESMA, with respect to the balance between position management and position limit tools, was also the subject of discussion.

114  Case 9/56, Meroni v High Authority [1957–1958] ECR 133. See further Ch XI sect 5.8.2.

115  The action must significantly address the threat to the orderly functioning and integrity of financial markets, including commodity derivatives markets (in accordance with the 2014 MiFID II Art 57 objectives) and including in relation to delivery arrangements for physical commodities, or to the stability of the EU financial system (or part thereof), or significantly improve the ability of NCAs to monitor the threat, as measured in accordance with the Art 45 regime; not create a risk of regulatory arbitrage; and not have the following detrimental effects on the efficiency of financial markets, disproportionate to the benefits of the measure—reduce liquidity in financial markets, restrain the conditions for reducing risks directly related to the commercial activity of a non-financial counterparty, or create uncertainty for market participants. ESMA must also consult with the Agency for the Co-operation of Energy Regulators (ACER) where the action relates to wholesale energy products, and with the public bodies responsible for the oversight, administration, and regulation of physical agricultural markets under the related EU regime, where the measure relates to agricultural commodity derivatives: Art 45(3).

116  Reflecting the sensitivity of ESMA’s powers, these rules do not take the form of RTSs.

117  Including with respect to the existence of a threat justifying action (and taking into account the degree to which positions are used to hedge positions in physical commodities or commodity contracts, and the degree to which prices in underlying markets are set by reference to the prices of commodity derivatives); the appropriate reduction of a position or exposure; and where a risk of regulatory arbitrage could arise: 2014 MiFIR Art 45(10). These administrative rules are to take into account the RTSs developed under the 2014 MiFID II Art 57 regime.

118  Measures must be reviewed at appropriate intervals and at least every three months. Where a measure is not renewed, it expires automatically. Renewal decisions are subject to the same conditions as apply to the original decision: Art 45(8).

119  Notification must be made not less than 24 hours before the measure is intended to take effect (or to be renewed), but shorter notification is permissible in exceptional circumstances.

120  The venue’s position management controls must be notified to the NCA who must communicate this information to ESMA.

121  An open interest position relates to the total of all futures and options contracts held.

122  Including in relation to the position’s size and purpose, the beneficial or underlying owners, concert arrangements, and any related assets or liabilities in the underlying physical market.

123  The reporting obligation applies only where the number of position holders and their open positions in a given financial instrument exceed minimum thresholds.

124  The report must distinguish between positions identified as positions which in an objectively justifiable way reduce risks directly related to commercial activities; and other positions.

125  ESMA is charged with centralized publication of position-related information.

126  The report must distinguish between positions identified as positions which in an objectively justifiable way reduce risks directly related to commercial activities and other positions.

127  As well as those of their clients and the clients of those clients until the end client is reached.

128  Directives 2011/61/EU OJ [2011] OJ L174/1 (2011 AIFMD) and Directive 2009/65/EC [2009] OJ L302/32 (2009 UCITS IV Directive).

129  The NCA must comply with notification obligations (to the other NCAs and ESMA) and the NCA receiving a notification may take similar action (2014 MiFID II Art 79(5)). ESMA is also conferred with related co-ordination powers, including with respect to the collation and publication of all such measures (2014 MiFIR Art 44(2)).

130  n 33. For an assessment of the Regulation see Payne, J, ‘The Regulation of Short Selling and its Reform in Europe’ (2012) 13 EBOLR 413. The main publicly available elements of the legislative history are: Commission Proposal COM (2010) 482, Impact Assessment SEC (2010) 1055; Parliament Resolution adopting a Negotiating Position, 5 July 2011 (T7-0312/2011) (ECON Report A7-055/2011); and Council General Approach, 11 May 2011 (Council Document 10334/11). The ECB opinion is at [2011] OJ C91/1.

131  Commission Delegated Regulation (EU) No 918/2012 [2012] OJ L274/1.

132  Commission Delegated Regulation (EU) No 826/2012 [2012] OJ L251/1 (this Regulation takes the form of an RTS, originally proposed by ESMA).

133  Commission Delegated Regulation (EU) No 919/2012 [2012] OJ L274/16 (this Regulation takes the form of an RTS, originally proposed by ESMA).

134  Commission Implementing Regulation (EU) No 827/2012 [2012] OJ L251/11 (this Regulation takes the form of an ITS, originally proposed by ESMA).

135  IOSCO, Regulation of Short Selling (2009) 23.

136  A covered sale, by contrast, has a number of stages, including the borrowing of the shares (to be provided to the buyer at settlement) by the short seller, the shorting of the shares by the short seller, the purchase of the same number of shares to be returned to the original lender, and the return of the shares to the original lender: FSA, Discussion Paper 09/1, Short Selling (2009) 6.

137  Accordingly, a seller of a CDS takes, in effect, a leveraged long position in the underlying reference bond, while a purchaser of a CDS takes a short position in the bonds: IOSCO, The Credit Default Swap Market (2012) 4.

138  For a policy view see FSA, n 136, 10.

139  The extensive literature generally finds that the restrictions contributed to volatility, negative pricing spirals, and a contraction of liquidity. See eg: Klein, A, Bohr, T, and Sikles, P, ‘Are Short Sellers Positive Feedback Traders? Evidence from the Global Financial Crisis’ (2013) 9 J of Financial Stability 337, Bebr, A and Pagano, M, ‘Short Selling Banks around the World: Evidence from the 2007–09 Crisis’ (2013) 68 J Fin 343, Gruenewald, S, Wagner, A, and Weber, R, ‘Short Selling Regulation after the Financial Crisis—First Principles Revisited’ (2010) 7 International J of Disclosure and Regulation 108, and Avgouleas, E, ‘A New Framework for the Global Regulation of Short Sales: Why Prohibition is Inefficient and Disclosure Insufficient’ (2010) 16 Stanford J of Law, Business and Finance 376. An extensive range of studies focus on particular markets. See, eg, Helmes, U, Henker, J, and Henker, T, The Effect of the Bank on Short Selling on Market Efficiency and Volatility (2009), available at <http://ssrn.com/abstract=1568435> (Australia), Arce, O and Mayordomo, S, Short Sale Constraints and Financial Stability: Evidence from the Spanish Ban 2010–2011 (2012), available at <http://ssrn.com/abstract=2089730> (Spain), and Boehmer, E, Jones, C, and Zhang, X, Shackling Short Sellers: The 2008 Shorting Ban (2011), available at <http://ssrn.com/abstract=1412844> (US).

140  For a policy perspective from the US SEC, see SEC Release No 34-61595, Amendments to Regulation SHO (2010) 13–14.

141  As is the case in the EU corporate bond market: 2010 Short Selling Proposal Impact Assessment, n 130, 13. CDSs were, presciently, initially analysed in the legal literature, immediately prior to the financial crisis, in Partnoy, F and Skeel, D, ‘The Promise and Perils of Credit Derivatives’ (2007) 75 U of Cincinnati LR 1019, which identified the hedging benefits of CDSs, their potential for bringing greater liquidity into credit markets by allowing banks to hedge their exposure more effectively, and their information transmission mechanism with respect to corporate performance (at 1023–7).

142  eg FSA, n 136.

143  The failure of the short seller to deliver the shares to the buyer on the due date.

144  Uncovered short sales raise similar issues as to the de-coupling of economic ownership and control rights as arise in relation to Contracts for Difference (CfDs) (Ch II sect 5.7).

145  Although the EU evidence suggests that settlement failures linked to short selling are limited, and were limited over the crisis: 2010 Short Selling Proposal Impact Assessment, n 130, 26–7.

146  ‘Locate’ rules, which require that the seller has made arrangements to locate and borrow the security in question (locate rules may, variously, require that the security is reserved for the seller or that best/reasonable efforts are made to ensure that the security is available), and related pre-borrowing rules, are designed to ensure that short sales are covered. They are associated with the reduction of settlement risk and of market disruption risk (in that an economic linkage exists between the demand for short selling activity and the supply of the related securities): IOSCO, n 135, 7–8.

147  Chief among these is the ‘uptick’ rule which was a feature of US securities regulation for some 70 years until it was abolished in 2007 (it was replaced by the ‘alternative uptick’ rule in 2010 (n 155)). Under the uptick rule, a short sale could not be carried out unless the last sale was of a higher price than the sale preceding it.

148  The US market has long been a laboratory for short selling rules, with short selling regulation a feature of US securities regulation since 1937. The US regime, now set out in Regulation SHO (2004), includes ‘locate rules’, circuit-breaker rules, an ‘uptick’ rule (n 155), and transparency rules, including with respect to the flagging of short sales.

149  In developing the new short selling regime, the Commission struggled to estimate the volume of short selling in the EU market, and drew mainly on proxy evidence from the UK (based on securities lending data) and from Spain in estimating the volume of short sales in shares at approximately 1–3 per cent of EU market capitalization: 2010 Short Selling Proposal Impact Assessment, n 130, 11–13. By contrast, some 50 per cent of total listed equity trading volume in the US market is thought to represent orders marked as short orders under the US flagging regime: SEC Release No-64383, Short Sale Reporting Study Required by Dodd-Frank Act, 3.

150  Enriques, L, ‘Regulators’ Response to the Current Crisis and the Upcoming Reregulation of Financial Markets: One Reluctant Regulator’s View’ (2009) 30 UPaJIL 1147.

151  Hu, H, ‘Too Complex to Depict? Innovation, “Pure Information” and the SEC Disclosure Paradigm’ (2012) 90 Texas LR 1601, at 1687–701, examining the new reliance on short selling regulation as a major departure for disclosure-based regulators.

152  IOSCO, Mitigating Systemic Risk. A Role for Securities Regulators (2011).

153  The UK FSA noted in relation to its action that ‘We did this at a time of extreme market turbulence, manifested in the form of high and prolonged price volatility and downward pressure on the prices of financial stocks in particular. We were concerned by the heightened risk of market abuse and disorderly markets posed by short selling in these conditions’: FSA, n 136, 3.

154  For a critique of the US, UK, and Australian interventions see Sheehan, K, Principled Regulatory Action. The Case of Short Selling (2009), available at <http://ssrn.com/abstract=1368531>.

155  The prohibition followed a 15 July 2008 temporary prohibition by the SEC of uncovered short sales in 19 financial institutions, in response to the destabilizing effect of rumours. The SEC subsequently adopted the ‘alternative uptick’ rule which applies when a share has triggered a circuit-breaker by experiencing a price decline of at least 10 per cent in a day, and which requires that short sales can take place only when the price of the share is the current national best bid price: Regulation SHO, Rule 201, SEC Release No 34-61595, Amendments to Regulation SHO (2010).

156  The prohibition (on net positions in excess of 0.25 per cent of the issued share capital) extended to uncovered and covered sales and to related transactions through derivatives. See Marsh, I and Payne, R, Banning Short Sales and Market Quality. The UK’s Experience (2010), available at <http://ssrn.com/abstract=1645847>.

157  On the Australian response see Hill, n 23, 256–61.

158  IOSCO adopted four principles: that short selling should be subject to appropriate controls to reduce or minimize potential risks to the orderly and efficient functioning of markets and the stability of markets; that short selling should be subject to a reporting regime (to markets or to regulators); that an effective compliance and enforcement system apply; and that any rules adopted allow for appropriate exemptions: n 135.

159  2010 Short Selling Proposal Impact Assessment, n 130, 25.

160  IOSCO’s 2012 report on the CDS market found that there was no conclusive evidence on whether taking short positions on credit risk through naked CDSs was harmful for distressed firms or for high yield sovereign bonds: IOSCO, n 137, 32–4. Similarly, the IMF has found that sovereign CDS spreads reflect economic fundamentals and other relevant market factors, that the sovereign CDS market is not prone to higher volatility than other market segments, that increases in sovereign CDS spreads do not cause higher sovereign funding costs, and, overall, that the evidence does not support a ban on uncovered sovereign CDSs and that a ban may reduce sovereign CDS market liquidity to the level at which these instruments become less effective as hedges and as indicators of credit risk: IMF, Global Financial Stability Report, April 2013, 57–92. Although Germany banned uncovered sovereign CDS trades in May 2010 in response to ongoing turmoil in sovereign debt markets in the EU, the BaFIN, Germany’s financial regulator, had earlier concluded that CDS trading had not affected Greek bonds: BaFIN, Press Release, 8 March 2010.

161  IOSCO has reported that globally, notional CDS exposure to private entities is x4 higher than exposure to sovereign entities, and that there has been relative stability in the size of the CDS market for euro-area sovereign debt since 2008: IOSCO, n 137, 7 and 9.

162  In 2010, the IMF cautioned against prohibiting uncovered sovereign CDS trades given evidence that most dealers in this market were not inclined to take directional bets, and the importance of these instruments, for, eg, hedging against counterparty risks and country corporate risks: IMF, Global Stability Report, April 2010, 49–53. Similarly, cautioning against restricting short sales in sovereign debt given the implications for risk management, Blommestein, H, Keskinler, A, and Lucas, C, The Argument Against Short Selling (2011), available at <http://ssrn.com/abstract=1927787>.

163  Early indications from the Commission suggested it supported a co-ordinated response through the G20 (Tait, N, Hall, B, and Oakley, D, ‘Dilemma over CDS Trades Policing’, Financial Times, 10 March 2010, 6). In March 2010, then FSB (Financial Stability Board) Chairman Draghi signalled some support for addressing the risks associated with speculation through CDSs: Peel, Q, ‘Call for Ban on CDS Speculation’, Financial Times, 11 March 2010, 6.

164  As at September 2010, ten Member States had no restrictions or conditions in place: Cyprus, Czech Republic, Estonia, Finland, Latvia, Malta, Romania, Slovakia, Slovenia, and Sweden.

165  For a list of the restrictions in place at September 2010 (the majority of which were imposed in autumn 2008) see 2010 Short Selling Proposal Impact Assessment, n 130, Annex 3. A list of restrictions was maintained by CESR (initially CESR/08/742) and since ESMA (ESMA/2011/399). For an examination of the French, German, and UK action see Payne, n 130, 424–8.

166  This was the most common form of requirement; of the 17 Member States which imposed some form of requirement, 11 imposed reporting requirements.

167  Imposed by eight Member States, (generally, not always) in relation to identified financial institutions.

168  Imposed by seven Member States (these prohibitions were typically imposed on shares of financial institutions and were temporary in nature).

169  The Commission had earlier consulted on whether short selling should be addressed in the market abuse regime reforms in its related 2009 Call for Evidence (a consensus emerged that short selling raised financial stability rather than market abuse risks and should not be addressed under the market abuse regime), and had included risk management procedures related to short selling in its 2009 AIFMD Proposal (COM (2009) 207, Art 11).

170  CESR, Proposal for a Pan-European Short Selling Disclosure Regime (2009) (CESR/09-581).

171  CESR, Model for a Pan-European Short Selling Disclosure Regime (2010) (CESR/10-088).

172  Earlier in May 2009, Greece had imposed a requirement for a flagging of short-sale orders and a circuit-breaker rule.

173  Peel, Q, ‘Call for Ban on CDS Speculation’, Financial Times, 11 March 2011, 6.

174  The Greek regulator banned the short selling of shares listed on the Athens Exchange; while this ban was lifted in August 2010, it was immediately replaced by a ban on uncovered short sales and subsequent measures followed.

175  Barber, T, Hall, B, and Wiesman, G, ‘German Curbs Raise Tensions in Europe’, Financial Times, 5 May 2010, 1. The prohibition applied to shares of the ten most significant financial institutions in Germany, euro-area sovereign debt, and sovereign debt CDSs: BaFIN Quarterly 2/2010, 3.

176  Germany’s action was widely linked to the domestic political agenda and disquiet in the Christian Democrat party, which reflected hostile feedback from constituents as to the cost of the euro-area bailout: Barber, T and Wiesmann, G, ‘Berlin makes Shock Moves without Allies’, Financial Times, 20 May 2010, 6.

177  German Finance Minister Schauble was reported as stating that the markets were ‘really out of control’ and that effective regulation was needed: Barber, T, Hall, B, and Wiesman, G, ‘German Curbs Raise Tensions in Europe’, Financial Times, 5 May 2010, 1.

178  House of Lords, EU Committee, Directive on Alternative Investment Fund Managers. 3rd Report of Session 2009–2010. Vol 1 (2010) 10 and 20–1.

179  ECON Committee Gauzès Report on the Alternative Investment Fund Managers Directive Proposal (A7-0171/2010). MEP Gauzès described naked shorting as a ‘casino game…a tool of pure speculation’: Johnson, S and Aboulian, B, ‘Europe Plans Ban on Naked Short Selling’, Financial Times Fund Management Supplement, 24 May 2010, 1.

180  Hughes, J, ‘Political Tide Turns on Regulation’, Financial Times, 20 May 2010, 6.

181  Commission, Public Consultation. Short Selling. June 2010. The Consultation addressed, inter alia, transparency requirements, restrictions on uncovered short sales, emergency powers, and the appropriate scope of a harmonized regime. Although the consultation responses were generally supportive of a harmonized approach and concerned as to unilateral Member State action, they revealed a lack of support, particularly from the market, for restrictions on uncovered short sales, and only limited support for applying the regime to asset classes other than equity. Although the consultation period was short, CESR had carried out an earlier consultation on short selling, which lasted for almost three months (CESR/09-581).

182  The 2010 Short Selling Proposal Impact Assessment drew heavily on the political concern in some Member States as to the potential impact of uncovered CDSs on the sovereign debt markets in justifying the Proposal: n 130, 5–6.

183  Tait, N, ‘Brussels in Bid to Take “Wild West” Markets’, Financial Times, 16 September 2010, 1.

184  2010 Short Selling Proposal Impact Assessment, n 130, 28–30.

185  2010 Short Selling Proposal Impact Assessment, n 130, 34.

186  eg AFME, ISLA, and ISDA, Summary of the AFME, ISLA, and ISDA position on Short Selling (May 2011), expressing the concerns of three major investment banking trade associations.

187  In its March 2011 Resolution in Innovative Financing it highlighted that short-termism and speculation in EU sovereign debt markets had been important aggravating factors in the euro-area sovereign debt crisis over 2009–2010: n 28, para I.

188  As was acknowledged by the Council in its July 2011 report on the negotiations, which noted the view in some quarters in the Parliament that uncovered CDS transactions were riskier than the lotteries permitted in Member States: 3105th Council Meeting, 12 July 2011 (Council Document 12481/2011).

189  Italy, in particular (whose sovereign debt came under repeated pressure over 2011) was concerned as to the impact of the Parliament’s CDS prohibition on its ability to manage its public debt: ‘EU Short Selling Talks Collapse amid Sovereign Debt Fears’, EurActiv, 22 September 2011.

190  The UK was opposed to any prohibition on uncovered sovereign CDSs given the potential prejudice to liquidity in the sovereign debt market, pressure on sovereign borrowing costs, damage to the ability of the EU to recover from the financial crisis, and damage to legitimate hedging activities: Wishart, I, ‘Council, MEPs at Odds on Short Selling and Supervision’ European Voice, 7 July 2011 and House of Commons, EU Committee, 20th Report of Sessions 2010–2012, The EU Financial Supervisory Framework: An Update.

191  Baker & McKenzie, EU Politicians Debate Short Selling Regulation, March 2011.

192  The European Parliament was initially not prepared to accept any loosening of its prohibition on uncovered sovereign CDS trading, leading to the possibility of the trilogue negotiations failing and the measure proceeding to a second reading: ‘EU Short Selling Talks Collapse amid Sovereign Debt Fears’, EurActiv, 22 September 2011.

193  Belgium, France, Italy, and Spain. Greece imposed a ban on short sales on 8 August 2011. The supportive ESMA statement is at ESMA/2011/266.

194  Industry reaction to the series of unco-ordinated prohibitions was hostile. The Managed Funds Association, eg, warned of the damage to risk management and of increased volatility: Letters to the Italian, Spanish, Belgian and German regulators, and to the ECB, the Council, the Commission, and ESMA, 13–15 August 2011.

195  The Polish Presidency announcement on the successful completion of the trilogue negotiations noted the extensive negotiations and the significant difference between the institutions’ positions: Polish Presidency Communiqué on Short Selling, 19 October 2011.

196  This element of the regime was one of the very last points of contention, and was not settled until after the Council and European Parliament had reached agreement on loosening the Parliament’s outright prohibition on uncovered sovereign CDSs: Alternative Investment Management Association, Note. EU Short Selling Regulation. October 2011, 6.

197  The removal of divergence recurs as a major rationale for intervention in the Regulation’s explanatory recitals: eg, recs 1, 2, and 5.

198  2012 Short Selling Regulation rec 2.

199  Commission, FAQ. Commission Delegated Regulation on Short Selling and CDSs. 5 July 2012 (MEMO/12/523).

200  eg n 150, n 154 and the references at n 139.

201  Even allowing for a degree of industry self-interest, some of the data produced in response to the 2011 Proposal was sobering. The lobby group for the EU investment firm industry, the AFME, suggested that the Commission’s requirement that instruments be reserved before a short sale (as part of the ‘locate’ rule—sect 3.7) could be qualified as ‘covered’ could drain 95 per cent of securities into reserve accounts, seriously damaging liquidity: AFME, ISLA, ISDA, Short Selling Position Summary. May 2011.

202  n 139. For an EU review see Bernal, O, Herinckz, A, and Szafarz, A, Which Short Selling Legislation is Least Damaging to Market Efficiency? Evidence from Europe, Centre Emile Berheim WP (2012), available at <http://ssrn.com/abstract=2011435>, finding that the prohibitions on covered short sales raised the bid–ask spread and reduced trading volume, that prohibitions on uncovered short sales raised volatility and the bid–ask spread, and that the new disclosure requirements raised volatility and reduced trading volume. The study concluded that prohibitions on uncovered short sales were the least damaging measures, as they did not impact on trading volume and addressed the risk of failure to deliver securities.

203  The evidence from an April 2010 workshop attended by the Commission and NCAs suggests that NCAs were divided as to whether and how uncovered equity short sales should be regulated and how the related ‘locate’ rule should be designed: 2010 Short Selling Proposal Impact Assessment, n 130, 88.

204  The regulation of trading in sovereign debt and sovereign CDSs suffers generally from a lack of data, as most market participants take up positions in auctions and maintain them in the secondary markets, and the securities are typically traded OTC: ESMA, Commission Delegated Regulation 918/2012 Technical Advice (2012) (ESMA/2012/236) 51. IOSCO has similarly highlighted the lack of direct research on the CDS market: IOSCO, n 137, 21.

205  CESR’s earlier attempts to develop a pan-EU disclosure regime noted the lack of a strong empirical base on which the new regime could be based. Its initial decision to opt for a 0.5 per cent of share capital threshold for public disclosure, eg, was largely based on applying a higher threshold than the 0.25 per cent threshold at which most of the autumn 2008 reporting requirements had coalesced, given the emergency conditions under which those requirements were adopted, rather than on empirical evidence: CESR Proposal, n 181, 9–10. Industry feedback to CESR’s proposal suggested significant disquiet at the lack of empirical evidence: CESR Feedback Statement (2009) (CESR/9-089) 4.

206  It noted the limited evidence on the impact of CDS trades on the sovereign debt markets and warned that the empirical evidence in favour of a prohibition was not strong: n 130, 25 and 43–4.

207  The Commission’s Impact Assessment Board supported the use of a precautionary model, however, given the lack of evidence. IAB Opinion, 31 August 2010 (Ref.Ares(2010)549585).

208  For a broadly positive examination of the contested CDS regime, which concludes that it is ‘more or less sound’ see Juurikkala, O, ‘Credit Default Swaps and the EU Short Selling Regulation’ (2012) ECFLR 307.

209  For an assessment of US SEC Regulation SHO (2004), which sets out the requirements with which a short sale must comply (including with respect to locating shares), and which is reflected in part in the EU regime, see Hu, n 151.

210  The review was to address: the appropriateness of the net short position reporting and disclosure thresholds; the impact of the individual net short position in shares disclosure requirements; the appropriateness of requiring direct, centralized reporting to ESMA; and the operation and appropriateness of the restrictions imposed on short sales and sovereign CDS transactions.

211  A related Call for Evidence was issued by ESMA in February 2013 (ESMA Call for Evidence on Evaluation of the Regulation (ESMA/2013/203)), following a Commission mandate. ESMA’s report was issued in June 2013 (ESMA/2012/614).

212  In accordance with 2012 Short Selling Regulation Art 42, which, reflecting the procedure for the adoption by the Commission of administrative acts generally (under Art 290 TFEU), provides for revocation of the delegations at any time by the European Parliament or Council, adoption by the Commission, and a veto by the Parliament or Council within three months of the measure’s adoption. On the procedure for adopting administrative rules see Ch X sect 4.

213  n 204.

214  SWD (2012) 198. The Commission also consulted with the Parliament, the ECB, and the European Securities Committee (on the role of this Committee in rule-making see Ch X): Commission, FAQ. Delegated Regulation on Short Selling and CDS, n 199.

215  See further Ch X.

216  The market consultations on the different administrative rules repeatedly reflected strong concerns as to the limited time for consultation and the time pressure under which the rules were being adopted: eg, Commission Delegated Regulation 918/2012 Impact Assessment (n 214) 66. ESMA also warned that its technical advice for Commission Delegated Regulation 918/2012 was being developed within a significantly compressed process which meant that it was not able to engage in a Call for Evidence, only a short consultation period (three weeks) was possible, and it was not possible to prepare a cost-benefit analysis for the consultation period: n 204, 5.

217  Commission Delegated Regulation 918/2012 broadly reflects ESMA’s advice. One notable departure from ESMA’s advice, however, relates to the highly contested question as to how correlation should be assessed in relation to whether a sovereign debt CDS is used for legitimate hedging and so is ‘covered’. The Commission adopted a mixed qualitative and quantitative approach, although ESMA (and the market generally) supported a qualitative approach. The Commission underlined, however, that ESMA’s approach to the qualitative test incorporated elements of a more quantitative approach: Commission Delegated Regulation 918/2012 Impact Assessment, n 214, 29 and 31. The RTS Regulations and the ITS Regulation were adopted by the Commission without any changes to ESMA’s proposals.

218  This was particularly the case in relation to the development of the notification thresholds for net short sovereign debt positions, where the Commission was keen to avoid onerous reporting obligations which would provide information of only limited systemic relevance: Commission Delegated Regulation 918/2012 Impact Assessment, n 214, 34.

219  Both the Commission and ESMA noted the paucity of evidence available in relation to the appropriate threshold for reporting of net short sovereign debt positions: Commission Delegated Regulation 918/2012 Impact Assessment, n 214, 33. In particular, no evidence was available on the average size of positions held by market participants in relation to sovereign debt.

220  The liquidity threshold at which NCAs can suspend the requirement for sovereign debt short sales to be covered, eg, was modelled against real sovereign debt histories for a sample of Member States to assess its resilience: Commission Delegated Regulation 918/2012 Impact Assessment, n 214, 38. Similarly, the rules specifying the ‘significant falls in value’ of particular instruments which can lead to an NCA taking emergency action drew heavily on market experience.

221  ESMA, Questions and Answers. Implementation of the Regulation on Short Selling and Certain Aspects of Credit Default Swaps (2012) (ESMA/2012/572). It is regularly updated and addresses technical matters of often significant operational complexity.

222  It is formally designed to promote common supervisory practices by NCAs and to ensure that supervisory practices converge, but is also designed to assist investors and market participants by providing clarity.

223  NCAs must also report on their compliance or explain their non-compliance. See further Ch X sect 5.6.

224  ESMA, Guidelines. Exemption for market making activities and primary market operations under the Short Selling Regulation (2013) (ESMA/2013/74) (2013 ESMA Market-Making Guidelines).

225  ESMA Annual Report (2012) 52.

226  The regime typically applies to ‘natural and legal persons’, termed ‘persons’ in this discussion.

227  Extraterritorial reach is not uncommon in the regulation of short sales. The UK autumn 2008 prohibition, eg, applied in relation to the identified UK shares, wherever trading occurred globally.

228  ESMA’s Q&A notes, eg, that the reporting requirements apply wherever a trade in relation to an in-scope instrument is executed or booked globally: n 221, 8.

229  On regulated markets and MTFs see Ch V.

230  As specified in 2014 MiFID II Annex 1 (see Ch IV sect 4.3).

231  The Arts 18, 20, and 23–30 powers apply to financial instruments generally.

232  A short sale in relation to a share or debt instrument is defined broadly as any sale of the share or debt instrument which the seller does not own at the time of entering into the agreement to sell, including a sale where, at the time of entering into the agreement to sell, the seller has borrowed or agreed to borrow the share or debt instrument for delivery at settlement: Art 2(1)(b). Three forms of transaction are excluded from the short sale definition: a sale by either party under a repurchase agreement where one party has agreed to sell the other a security at a specified price with a commitment from the other party to sell the security back at a later date at another specified price; a transfer of securities under a securities lending arrangement; and entry into a future contract or other derivative contract, where it is agreed to sell securities at a specified price at a future date. The nature of ‘ownership’ for the purpose of the short sale definition has been amplified by the 2012 Commission Delegated Regulation 918/2012 Art 3.

233  Sovereign debt is defined as a debt instrument issued by a sovereign issuer (Art 2(1)(f)). A sovereign issuer is widely defined as including the EU, a Member State (including a government department, agency, or SPV (special purpose vehicle) of the Member State), a member of the federation in the case of a federal Member State, an SPV for several Member States, an international financial institution established by two or more Member States which has the purpose of mobilizing funding and providing financial assistance to the benefit of its members that are experiencing or threatened by severe financing problems, and the European Investment Bank: Art 2(1)(d).

234  A CDS is defined as a derivative contract in which one party pays a fee to another party in return for a payment or other benefit in the case of a credit event relating to a reference entity, and of any other default relating to that derivative contract which has a similar economic effect (Art 2(1)(c)). A sovereign CDS is one where a payment or other benefit is paid in the case of a credit event or default relating to a sovereign issuer (Art 2(1)(e)).

235  As confirmed in ESMA’s Q&A, Q1a, 1b and 1e.

236  Determined in accordance with the rules which determine which NCA is responsible in relation to transaction reporting under MiFID II/MiFIR (see Ch V sect 12.1).

237  In relation to the calculation of turnover (2012 Commission Delegated Regulation 826/2012 Art 6) and the timing of the calculation and related reviews (2012 Commission Implementing Regulation 827/2012 Arts 8–11).

238  Including investment firms, credit institutions, and third country entities.

239  The conditions for the equivalence determination are set out in Art 17(2). Although the actor in question must be a member of a trading venue or third country market, the actor is not required to conduct its market-making activities on that venue/market or to be recognized as a market maker on that venue/market: 2013 ESMA Market-Making Guidelines, n 224, 7. The restriction of the exemption to members of a trading venue has, however, limited the availability of the exemption for OTC market-making activities and has been identified by ESMA as in need of reform (sect 3.13).

240  The firm can post simultaneous two-way quotes of comparable size and at competitive prices, with the result of providing liquidity on a regular and ongoing basis to the market; it can, as part of its usual business, fulfil orders initiated by clients or in response to clients’ requests to trade, or it can hedge positions arising from the fulfilment of the latter two tasks: Art 2(1)(k).

241  2012 Short Selling Regulation rec 26.

242  Defined as a person who has signed an agreement with a sovereign issuer or who has been formally recognized by a primary dealer by or on behalf of a sovereign issuer and who, in accordance with the agreement or recognition, has committed to dealing as principal in connection with primary and secondary market operations relating to debt issued by that issuer: Art 2(1)(n).

243  Notification in relation to the market-making exemption must be made to the home NCA of the relevant entity (a third country actor must notify the NCA of the main trading venue in the EU on which it trades); notification in relation to the authorized primary dealer exemption must be made to the NCA of the Member State which has issued the sovereign debt in question: Art 17(5)–(8).

244  n 224.

245  n 224, 3–4.

246  The Guidelines highlight, eg, that the exemption applies on a financial instrument basis and that the conditions which apply to the market-making exemption must accordingly be met in relation to each financial instrument in respect of which exemption is sought, reflecting Commission advice to this effect: n 224, 7. Accordingly, where an instrument is not admitted to a trading venue, the exemption is not available as, to qualify for the exemption, the actor must deal as principal in the trading venue in which it is a member in the financial instrument for which the exemption is notified. They also provide that the required notification applies on a per instrument basis, although several financial instruments can be addressed in a single notification (at 16–18). ESMA has also suggested that actors benefiting from the exemption should not hold significant short positions in relation to market-making activities other than for brief periods: at 7.

247  Detailed guidance applies, eg, to the qualifying criteria for when an actor posts firm two-way quotes with the result of providing liquidity under Art 2(1)(k)(i): 11–14.

248  ESMA Guidelines Compliance Table (ESMA/2013/765).

249  The Guidelines provide that to qualify for the exemption, the market-maker must be a member of the market/trading venue in which it deals as principal in the financial instruments for which it notifies the exemption (n 224, paras 19–22 and 35–36). Four NCAs (Denmark, Germany, the UK, and Sweden) disagreed with this interpretation of 2012 Short Selling Regulation Art 2(1)(k), which, as noted (n 246), is based on ESMA’s view that the Art 2(1)(k) criteria must be met with respect to every financial instrument in respect of which a notification is made. The UK, eg, based its reasons for not complying on its interpretation of Art 2(1)(k) which, the UK argued, requires trading venue membership, but does not expressly require that the financial instrument in respect of which exemption is sought must be traded on the trading venue in question. The German BaFIN similarly rejected ESMA’s interpretation, arguing that it could take market-making in sovereign CDSs outside the exemption as these instruments are often not admitted to trading venues.

250  The 2012 Short Selling Regulation highlights that short selling plays an important role in ensuring the proper functioning of financial markets, particularly with respect to liquidity and price formation: rec 5.

251  The Commission and European Parliament took a restrictive approach to the locate rule, requiring that the locate confirmation confirm both that the third party in question had located the securities and that the securities were reserved for lending. The Council’s more facilitative approach prevailed in the 2012 Short Selling Regulation as finally adopted.

252  The different arrangements are based on EU market practice as well as on the US regulatory framework for short sales: Commission FAQ, Short Selling Technical Standards, 29 June 2012 (Memo/12/508).

253  The Art 12(2) delegation required ESMA in developing the rules to take into account intraday short sales and the liquidity of the shares being sold short.

254  Lighter conditions apply in relation to Art 6(3) and (4) arrangements. In particular, the third party must provide the locate confirmation, but need only confirm that the share is easy to borrow or purchase in the relevant quantity, taking into account market conditions (the ‘put on hold’ confirmation does not accordingly apply).

255  2012 Commission FAQ, Short Selling Technical Standards, n 252. Art 8 applies to arrangements relating to covered short sales of shares and of sovereign debt, and identifies CCPs, securities settlement systems, central banks (which, respectively, clear, settle, or accept as collateral/conduct open market or repo transactions in relation to the relevant securities), and national debt management entities for the relevant sovereign debt issuers. Investment firms, other persons authorized or registered by a member of the European System of Financial Supervision (ESFS), and equivalent third country persons are also included where they participate in the management of borrowing or purchasing of the relevant shares or sovereign debt, provide evidence of such participation, and, on request, can provide evidence of ability to deliver the shares or sovereign debt on the dates on which they have committed to do so.

256  As was acknowledged by the Commission: 2012 Commission FAQ, Short Selling Technical Standards, n 252.

257  Concern over prejudice to liquidity in the sovereign debt market led to ESMA being expressly charged with preserving liquidity when developing the regime: 2012 Short Selling Regulation Art 13(5).

258  In essence, the locate regime for sovereign debt does not require that the securities are placed on hold by the third party. In the standard arrangement, the third party, prior to the sale being entered into, must confirm that it considers that it can make the sovereign debt available for settlement in due time, in the amount requested by the person, taking into account market conditions, and indicate the period for which the sovereign debt is located (Art 7(1)). Art 7 also covers time-limited intraday confirmations, unconditional repo confirmations, and ‘easy to purchase’ confirmations, all of which qualify the sale as a covered sovereign debt short sale.

259  Although it is not expressly addressed by the administrative regime, the Commission has suggested that high correlation means a correlation of 80 per cent: 2012 Commission FAQ, Commission Delegated Regulation on Short Selling and CDSs, n 199.

260  The NCA of the Member State which has issued the debt: Art 2(1)(j)(i).

261  Including the total amount of outstanding issued sovereign debt for each sovereign issuer: Art 13(4).

262  Commission Delegated Regulation 918/2012 Impact Assessment, n 214, 35.

263  Art 22. Turnover is defined as the total nominal value of debt instruments traded, in relation to a basket of benchmarks with different maturities. In performing these calculations the NCA must use representative data readily available from one or more trading venues, from OTC trading, or from both, and inform ESMA of the data used. The NCA must also ensure that the significant drop in liquidity is not as a result of seasonal effects. A basket approach was adopted as providing the best proxy for the liquidity of the sovereign debt market as a whole, given different issues and maturities, and avoiding the complexities engaged with assessing liquidity in relation to every issue: 2012 ESMA Commission Regulation 918/2012 Technical Advice, n 204, 51.

264  The European Parliament highlighted the political weight which would attach to a negative opinion from ESMA: Parliament Press Release, Crack Down on Short Selling and Sovereign Debt Speculation (Ref 201110181PR29720).

265  A generous approach to correlation could lead to almost any hedge being deemed as ‘covered’: 2012 Commission Regulation 918/2012 Impact Assessment, n 214, 8.

266  The Commission considered the relative merits of qualitative and quantitative approaches in some detail and despite ESMA’s support for a qualitative approach, chose a mixed approach: 2012 Commission Regulation 918/2012 Impact Assessment, n 214, 22–3 and 26–31.

267  The correlation is assessed in relation to the price of the assets or liabilities, and the price of the sovereign debt, calculated on a historical basis using data for at least a period of 12 months of trading days immediately preceding the date when the CDS position was taken out: Art 18(1)(a).

268  The 70 per cent condition is met where the exposure being hedged relates to: an enterprise which is owned, majority owned, or has its debts guaranteed by the sovereign issuer; a regional, local, or municipal government of the Member States; an enterprise whose cash flows are significantly dependent on contracts from a sovereign issuer; or a project which is funded, significantly funded, or underwritten by a sovereign issuer, such as an infrastructure project: Art 18(2).

269  Art 18(1)(b). The time frame for the calculation of the correlation is specified.

270  Any uncovered sovereign CDS positions created over the suspension period can be held until maturity: 2012 Short Selling Regulation Art 46(2). Reporting requirements also apply under Art 8.

271  NCAs may also use other indicators.

272  The NCA of the relevant sovereign: Art 2(1)(j).

273  Settlement is also being addressed more generally through the new regime for central securities depositaries (noted in Ch V sect 13).

274  2012 Short Selling Regulation rec 23.

275  The flagging model was opposed by the Council. Post-trade transaction reports which identify short sales are, however, required under the 2014 MiFID II/MiFIR reporting regime: Ch V sect 12.1.

276  Only Poland and Greece applied flagging rules when the 2012 Short Selling Regulation was under negotiation.

277  In developing its short selling reporting regime for equities, CESR warned of imperfections in flagging-related data, that such data might simply replicate that already available from proxy sources, notably in relation to securities lending, while imposing significant costs, and that this data did not provide disclosure on aggregate individual short positions: 2010 CESR Proposal, n 170, 6.

278  Defined as the total of ordinary and preference shares issued by the company, but not including convertible debt securities: Art 2(1)(h).

279  No person is required to obtain any real time information as to such composition from any person (Art 3(3)).

280  2012 Commission Delegated Regulation 918/2012 Art 4 (linking the ‘holding’ of a share to owning the share and having an enforceable claim to be transferred ownership of the share).

281  Including in relation to the weight to be given to long positions held in shares through a basket of shares, and in relation to the instruments which can generate a long position by conferring a financial advantage in the event of an increase in the share price (essentially, a wide range of derivative instruments (including spread bets and CfDs) which provide exposure to share capital): 2012 Commission Delegated Regulation 918/2012 Art 5. This approach also applies to the calculation of short positions: Art 6. The Commission Regulation also specifies that for the purposes of the net short position calculation it is irrelevant whether cash settlement or physical delivery of the underlying assets has been agreed, and that short positions on financial instruments that give rise to a claim to unissued shares, and subscription rights, convertible bonds, and other comparable instruments, are not to be considered as short positions: Art 7.

282  2012 Commission Delegated Regulation 918/2012 Art 13.

283  2012 Commission Delegated Regulation 918/2012 Art 12.

284  Defined as the total of sovereign debt issued by a sovereign issuer that has not been redeemed: Art 2(1)(g).

285  See n 287.

286  A sale of a CDS is considered to represent a long position, and a purchase a short position: 2012 Commission Delegated Regulation 918/2012 Art 9(3).

287  As for shares, the calculation of net short positions in sovereign debt has been amplified by the 2012 Commission Delegated Regulation 918/2012 Arts 8–9, which address similar issues to Arts 5–7 in relation to shares, but additionally address when sovereign debt of another issuer is ‘highly correlated’ and so included in the calculation of the related long position. It specifies that sovereign debt of non-EU sovereign issuers may not be included in the calculation of the long position, and that instruments are highly correlated where there is an 80 per cent correlation coefficient between the pricing (or yield) of the debt instrument of another sovereign issuer and the pricing of a given sovereign issuer over a 12-month period preceding the position (Art 8(3) and (5)).

288  The determination of the relevant NCA is carried out according to the rules which govern the relevant NCA for the purposes of transaction reporting under MiFID II/MiFIR (Ch V sect 12.1): Art 2(1)(j).

289  The model on which CESR consulted was originally more stringent, applying at 0.1 per cent of share capital. CESR revised the threshold upward to 0.2 per cent, given evidence from the UK FSA that a 0.1 per cent threshold could lead to over-reporting and related inefficiencies: CESR Feedback Statement/10-089, 12.

290  The higher threshold reflects the potential risks to the position holder (who might become vulnerable to moves against the position once it is disclosed) as well as the herding risks which might generate market instability were trading to follow the direction of the disclosed positions to a significant extent. While CESR acknowledged these risks in designing its disclosure model, it also warned that there was limited empirical evidence to suggest the risks were significant in practice: 2010 CESR Proposal, n 170, 7–9.

291  Art 6 applies without prejudice to rules which may apply at national level, and in accordance with EU law, in relation to the disclosure of positions held in the context of takeover transactions: Art 6(5).

292  In both cases, ESMA is empowered to provide an opinion to the Commission on adjusting the reporting thresholds, and the Commission is empowered to adopt related revising administrative rules (Art 5(3) and (4) and Art 6(3) and (4)).

293  The inclusion of sovereign debt (and, in certain circumstances, uncovered sovereign CDSs) reflects the prevailing political climate at the time of the Regulation’s adoption. In limiting its reporting regime to shares, CESR simply noted that it was not appropriate to extend the reporting regime to other asset classes, given the specific issues raised by shorting of shares: 2010 CESR Proposal, n 170, 8.

294  Including in relation to a lack of data, the practical difficulties generated by frequent new issues of sovereign debt and the maturing of issues, differing levels of liquidity in different sovereign debt markets, and the danger of over-reporting where thresholds are set at too low a level.

295  The classification is based on the need to ensure that the thresholds do not lead to over-reporting of positions of minimal value, to reflect, accordingly, the total amount of each sovereign’s debt and the average size of the related positions, and to reflect the relative liquidity of each sovereign’s debt: Art 21(5) and 2012 Short Selling Regulation Art 7(3).

296  The monetary amounts are reviewed on a quarterly basis by ESMA to reflect changes in the total amount of outstanding debt, while the placing of Member States within particular baskets is reviewed annually: 2012 Commission Delegated Regulation 918/2012 Art 21(3) and (9). ESMA has recommended that the thresholds be recalibrated in light of initial experience with the 2012 Short Selling Regulation, and that the current quarterly review of monetary amounts take place on an annual basis, given that amounts of EU issued sovereign debt remain broadly stable (sect 3.13).

297  2012 Commission Delegated Regulation 826/2012 Art 2.

298  2012 Commission Implementing Regulation 827/2012 Arts 2 and 3.

299  2012 Commission Delegated Regulation 826/2012 Arts 4 and 5 and 2012 Commission Implementing Regulation 827/2012 Arts 3 and 4.

300  The nature of these adverse events or developments has been amplified by the 2012 Commission Delegated Regulation 918/2012 Art 24 which (in outline) identifies any act, result, fact, or event that is or could reasonably be expected to lead to: serious financial, monetary, or budgetary problems which may lead to financial instability concerning a Member State or bank and other financial institution deemed important to the global financial system; a rating action or default by any Member State or bank and other financial institution deemed important to the global financial system; substantial selling pressures or unusual volatility causing significant downward spirals in any financial instruments related to any bank and other financial institution deemed important to the global financial system; any relevant damage to the physical structures of important financial issuers, market infrastructures, clearing and settlement systems, and supervisors; and any relevant disruption in any payment system or settlement process.

301  This power does not apply where the financial instrument is already subject to transparency requirements under the Regulation: Art 18(2).

302  The NCA may apply the restriction to all financial instruments, financial instruments of a specific class, or a specific financial instrument, and may provide for exceptions (including in relation to market-making and primary dealing activities).

303  As under Art 20, the NCA may apply the restriction to all sovereign CDS transactions of a specific class, or to specific sovereign CDS transactions, and may provide for exceptions (including in relation to market-making and primary dealing activities).

304  The circuit-breaker power is designed to empower NCAs to slow a negative price spiral without needing to show, at the same time, the exceptional, emergency conditions on which emergency intervention is otherwise dependent.

305  Exceptions may be provided for (Art 23(3)).

306  Art 23 specifies the qualifying falls in value in a single trading day as: 10 per cent, 20 per cent, or 40 per cent or more for semi-liquid shares, ‘penny shares’ (shares with a nominal value of at least 50 cent), and illiquid shares, respectively; an increase of 7 per cent or more in the yield across the yield curve for the relevant sovereign issuer; an increase of 10 per cent or more in the yield of a corporate bond; a decrease of 1.5 per cent or more in the price of a money-market instrument; and a decrease of 10 per cent or more in the price of an exchange-traded fund (ETF). Where a derivative is traded on a trading venue and its only underlying financial instrument is a financial instrument for which a significant fall in value has been specified, a significant fall in value of the derivative is deemed to occur where there has been a significant fall in the underlying financial instrument.

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