Brexit threatens to trip up derivatives reporting

Split will increase firms’ workload and costs, and result in less-accurate regulatory reports

The story of derivatives reporting in Europe could be called ‘How to make life harder in three easy steps’. The first two steps – the overlapping requirements in the European Market Infrastructure Regulation and its younger sibling Mifir – will soon be crowned by Brexit, and neither firms nor their overseers will escape unharmed.

Brexit will force changes to the fragile reporting arrangements brought in by Emir and the Markets in Financial Instruments Regulation, increasing complexity, firms’ costs and chances of mistakes in the reports of derivatives trades sent to regulators.

“Firms are still so busy remediating and improving the infrastructure supporting transaction reports [in Mifir] and the reporting obligation [in Emir] – throw in Brexit now and it just adds another layer of potential issues to the entire reporting framework,” says a financial industry source.

Brexit will muddy the waters in several ways. Firstly, as many UK and non-European Union financial firms are setting up offices in the bloc, they will have to replicate their Emir and Mifir reporting systems in the new entities.

When filing a report on behalf of a client under Emir, dealers will sometimes have to report the trade to two trade repositories.

Likewise, under Mifir, many firms will have to report the same trade twice: once to UK regulators and once to continental watchdogs. Brexit will also produce two different lists of instruments reportable under Mifir.  

Lastly, both under Emir and Mifir, swaths of exchange-traded derivatives (ETDs) could be treated as over-the-counter instruments by either jurisdiction, introducing subtle changes to the details that need to be disclosed.

“Any kind of additional complexity increases the risk of errors,” says Alan McIntyre, a senior business analyst at reporting software provider RegTek Solutions, who is also in charge of the firm’s relations with the financial industry and regulators.

These problems are most likely to crop up if the UK leaves the EU without a deal. If, however, the UK parliament approves the existing deal on March 12 or, after a short extension, later this year, a transition period lasting until the end of 2020 should allow the two sides to reach equivalence agreements. The two options for such agreements would then ease the Emir reporting burden (see box: Escape hatch).

The prudent thing to do is to prepare for the worst: either no deal or no equivalence. But, with Brexit outcomes highly unpredictable, firms are reluctant to change their reporting arrangements just yet, says the industry source.

“These tweaks could be made and then suddenly, in the not-so-distant future, an equivalence decision is granted or a Brexit deal is made, and then it is just another headache to unravel the efforts that have gone into amending the systems and to spend further money making those changes.”

The person hopes regulators will allow a grace period after Brexit so that firms can adjust to the new rules without being penalised for non-compliance.

Duplication aggravation

Under Emir, most institutional users of derivatives have had to disclose certain details of their derivatives trades to regulators since 2014. Mifir, which came into force in January 2018, also obliged investment firms, including banks and asset managers, to provide slightly different information on a sub-set of their derivatives deals.

The reporting channels also differ: Emir data must be submitted through trade repositories, while Mifir data must be sent to regulators either by the firm itself, or via a so-called Approved Reporting Mechanism (ARM), or by the trading venue that executed the transaction.

The first difficulty Brexit creates for derivatives reporting has to do with the fact many firms are opening subsidiaries in continental Europe to ensure they can still operate there after Brexit. And, as the UK intends to copy Emir and Mifir in its own law, banks will have to follow both version of the regimes.

The consequences are twofold.  

“The real duplicative costs for firms are replicating systems, controls and infrastructures in new entities,” says Chris Dingley, a sales director at consultancy CME Regulatory Reporting.

Then, a typical bank with entities in both jurisdictions will have to start paying four rather than two sets of annual fees: to a trade repository and an ARM in the UK, and to the equivalent pair in the EU.

That is because after Brexit, absent an equivalence deal, only EU-based repositories will be allowed to submit trade reports to regulators in the bloc. After a temporary registration regime ends, the UK will introduce the same constraint.

The same will apply to ARMs in both jurisdictions – the difference is there is no equivalence-based workaround for ARMs and there will be no UK temporary registration regime for these service providers.  

The next problem arises in delegated reporting – a common practice among dealers involving the reporting of Emir data on behalf of end-users.

Emir requires both counterparties to send the details of their trade to a trade repository, and each counterparty must use a repository in its own jurisdiction. As a result, a single trade between a UK dealer and an EU client, for example, will have to be reported to two different repositories. In a delegated reporting scenario this will be done by the dealer.

[Post-Brexit Mifir reporting] is for the regulators’ market surveillance, but it is duplicative and costly

Jason Waight, MarketAxess

The same kind of double reporting will afflict Mifir compliance after Brexit, because – unike Emir – the Mifir obligation applies not only to EU investment firms but also to the local branches of firms from third countries, such as the post-Brexit UK. The UK plans to mirror this requirement in its version of Mifir.

So, an EU bank’s London branch will have to report to the UK’s Financial Conduct Authority (FCA) while the bank’s head office will have to disclose the same trade to the relevant national EU regulator. The duplication will suck up time and – especially if the reporting is done via ARMs – money, as ARMs, like trade repositories, charge per report in addition to the annual fee.

“It is for the regulators’ market surveillance, but it is duplicative and costly,” says Jason Waight, head of regulatory affairs at MarketAxess and its subsidiary Trax, which provides regulatory reporting services.

Mifir reporting will be complicated further by the fact that one set of instruments will be in scope of the original EU regime and an overlapping but different set of instruments will be covered by the future UK version of Mifir.

Mifir captures instruments that are traded or available for trading on a venue in the European Economic Area, and those where the underlying or the underlyings are traded on an EEA venue. Once the UK leaves the bloc, instruments traded only on UK venues will drop off the list.

In contrast, the UK plans to clone Mifir regulatory reporting rules in their current form – that is, capturing both UK- and EEA-traded instruments.

Curiouser and curiouser

An even stranger consequence of Brexit is the mutation of some ETDs into OTC instruments from the perspective of the other jurisdiction. As Emir and Mifir currently stand, once the UK leaves the EU, the bloc will disregard any trading on a UK venue, tipping those derivatives into the OTC category. Again, as London aims to replicate both regimes, the same mutation will affect EU-traded ETDs.  

“People are really concerned what the transformation of ETDs into OTC products could imply for reporting,” says the industry source. “Do I really need to report what we see as bread-and-butter ETDs as an OTC instrument? How does the information need to change?”

One necessary change will apply to the execution field required by Emir and Mifir: it will have to contain the code for off-venue trading – X-OFF – instead of the venue’s identifier code.

A subtler change that not many firms may be aware of will be the personal identifier for traders with dual nationality, mandated by Mifir. Such traders are identified by the EEA country and, if they are citizens of two EEA states, it is the country that comes first alphabetically.

For example, a British-Irish or British-Italian trader currently uses the country code for the UK – GB. However, once the UK drops out of the EEA, the trader will need to be assigned the country code for Ireland or Italy.

“You’ve got two very complex reporting regimes, which are set to become even more complicated,” concludes David Nowell, an Emir and Mifir expert at regulatory technology vendor Kaizen Reporting. “There are possible changes to the reporting fields, including personal identifiers, and this is compounded by differences in the reportable instrument set. It is bound to lead to more errors.”

I question whether it is actually possible to pair and match [trade reports] post-Brexit

Financial industry source

The upshot for regulators is that Brexit will make derivatives reports less reliable, both under Mifir and Emir, which is designed to catch errors.

Unlike Mifir, the older legislation requires both counterparties to report trades to repositories. The repositories match the reports, which regulators then scrutinise for discrepancies. This kind of verification, already troublesome, may become impossible if the UK and the EU no longer share data from their respective repositories after Brexit.

“I question whether it is actually possible to pair and match post-Brexit,” says the industry source. “It depends entirely on where the reports are being sent to [to the same jurisdiction or different ones] and the level of data sharing that may or may not occur after Brexit. It will be difficult for regulators to conduct the process if they aren’t sharing data.”

For firms, though, there is a sliver of silver lining: if regulators can’t cross-check reports, neither can they compel counterparties to correct or explain any discrepancies.

Escape hatch

Two possible equivalence determinations would provide a way out of the post-Brexit nightmare of Emir reporting.

The EU can choose to recognise third-country trade repositories as equivalent to its own. Equivalent repositories can then serve as a conduit between EU firms and EU regulators and vice versa, if the FCA deems the bloc’s repositories equivalent, they can be used in the UK.

This would make life easier for firms because the same repository could be used for reporting both to EU and UK regulators, whether for direct or delegated reporting.

In a side-effect, not related to derivatives, such equivalence will also prevent double reporting for repos, points out Jeremy Jennings-Mares, a partner at law firm Morrison & Foerster. Incoming reporting rules contained in the EU’s Securities Financing Transactions Regulation require EU firms, EU branches and subsidiaries of third-country firms, and third-country branches of EU firms to report repo transactions to EU-based or equivalent repositories. The rules are due to come into force in the middle of 2020.

The second equivalence determination that would reduce the Emir reporting workload concerns trading venues. EU law classifies a derivative contract as exchange-traded if it is traded either on an EU ‘regulated market’ or on a third-country market in a jurisdiction deemed equivalent for the purposes of the trading obligation for OTC derivatives.

If the UK is deemed equivalent in this way and the FCA reciprocates, then neither EU nor UK ETDs will transform into OTC instruments.

There are, however, no possible equivalence provisions that would prevent double reporting of derivatives, as well as bonds and equities, under Mifir.

 

Costs of separation

Aware of the Brexit implications on derivatives reporting, a number of UK and EU trade repositories and ARMs have set up or plan to set up entities in the other jurisdiction so they can retain their share of the business even after the two part ways (see table: Brexit moves by trade repositories, ARMs and APAs).

Financial firms worry the service providers will now increase their fees to cover the higher costs of running two or more separate entities.

Repositories reporting derivatives under Emir are expressly required to ensure fees are “cost-related”.

“It would be unclear to me how they could soak up the cost if they truly are on a cost-recovery-like basis,” says a compliance expert at a UK bank.

Alan McIntyre at RegTek Solutions is more categorical: “Splitting will definitely increase costs for repositories.”

The cost constraint on fees does not apply to ARMs or to Approved Publication Arrangements (APAs), which support another type of disclosures – to the public.

Risk.net has asked reporting service providers with second homes whether they will raise their fees. The DTCC trade repository says it won’t. The London Stock Exchange, which runs a trade repository, an ARM and an APA, says the fees for all three will stay the same this year. A spokesperson for Bloomberg says: "We have no plans at this time to increase the fees for our APA and ARM services due to Brexit." CME Regulatory Reporting has no plans to increase fees at this time.

A spokesperson for Deutsche Börse’s trade repository provides a more nuanced answer: “Annual fees for market participants sending EU27 flow to Regis-TR SA [in the EU] will be unaffected by Brexit and the establishment of the UK TR… Fees for market participants sending UK flow to Regis-TR UK Ltd will be priced on a cost-plus basis and at a very similar level to the fee schedule for Regis-TR SA, i.e. very competitive.”

Trax ARM and APA declined to comment. 

Update, March 11, 2019: The article has been updated to state that CME will not be raising fees.

Editing by Olesya Dmitracova