Almost a decade ago at the 2009 Pittsburgh Summit, G20 Leaders committed to reform the OTC derivatives markets with the objective of reducing systemic risks, improving transparency and protecting investors against market abuse.i To fulfil this commitment in the EU, MiFID II introduced specific requirements to the derivatives markets in order to bring more trading onto venues and increase the level of price transparency in these financial instruments as of 3 January this year.ii MiFID II also significantly enhanced the transaction reporting regime, designed to provide information to enable regulators’ monitoring and detection of market abuse. As a consequence firms subject to MiFID II have to report much more information about their derivative transactions.While there are several initial operational challenges in the new market data regime, we expect the European Securities and Markets Authority (ESMA) to further clarify its expectations for reference data reporting, including the pre- and post-transparency and transaction reporting requirements for OTC derivatives that are “Traded on a Trading Venue”.iii Over the next few months, we expect market data to become more consistent and reliable with the harmonisation of reporting practices, particularly in the OTC and derivatives markets, for which data quality has been lower historically due to a lack of transparency. Firms should view this as opportunity to optimise their analytical capabilities so that they can identify how to utilise the higher quality and more consistent data as they become increasingly available in the market, and optimise their trading and services on behalf of their clients.iv
Challenges with market reference data
Several issues currently arise from a lack of uniformity in market reference data for OTC derivatives. This is mostly due to firms’ reliance on International Security Identification Numbers (ISINs) as instrument identifiers to understand whether a derivative instrument is ToTV, and national regulators’ different interpretations as to whether the OTC derivative has to have an ISIN (among other data fields) that matches the on-venue derivative reported in ESMA’s central Financial Instrument Reference Data System (FIRDS).
As the requirement is new, ISINs are not yet available for all OTC financial instruments. ESMA’s market reference database also records evidence of duplicative ISINs produced for the same instrument, as a result of firms giving different descriptions to the same derivative instrument. Another issue is that because market participants face the challenge of not knowing whether a product is ToTV as they trade, they may under-report or over-report their transactions, which may add to the inaccuracy of market reference data for some derivatives.
For regulators, pricing transparency for OTC derivatives for investors is a key objective of MiFID II to ensure that investors get the best possible market price. If firms continue to experience uncertainty around the reporting requirements, and market reference data remains incomplete to provide a full view of all instruments that should be included, we fully expect ESMA to issue more guidance on the subject. In its Supervisory Convergence Work Programme for 2018, ESMA has already signalled that it may review its opinion on ToTV based on market developments in the first months of MiFID II application.v
What does this mean for industry participants?
As supervisory expectations around transaction reporting, pre- and post-trade transparency and best execution become more stringent over 2018, firms must first address areas where their implementation may have fallen short before national regulators begin to contemplate enforcement actions. While the first months of MiFID II have presented some data and reporting challenges for firms and regulators alike, firms should look to the coming months as an opportunity to move beyond achieving compliance with their regulatory obligations and enhance their analytical capabilities to enable them and their clients to benefit from the broader range of data that will be available.
Data quality sits high on the pan-EU capital markets regulatory agenda, and we expect it to continue to be a priority for ESMA, which over the course of 2018 is looking to develop and apply detailed data quality methodologies under MiFIR, such as for transaction reporting, reference data and transparency calculations. vi In its priorities for wholesale financial markets for 2018/19, the FCA also confirmed that its supervision work for the year ahead will focus on ensuring that firms are complying with changes under MiFID II.vii
To get ahead of the curve, firms could find solutions to leverage the new and more abundant market data to formulate their post-MiFID II strategies for trading, while bearing in mind that such solutions should enhance investor protection and market integrity, and not compromise data privacy. In particular, firms should develop tools to help validate their reporting data, and use the data they collate for reporting purposes to analyse client trading patterns, as well as where to trade to get the best prices. The data also increases the scope of monitoring that can be done for derivatives trading, and enables better best execution monitoring for instruments for which previously the breadth of data was too limited to be drawn upon to demonstrate execution quality. This will particularly be important as regulators start scrutinising firms’ compliance with regulatory obligations under MiFID II.
i Financial Stability Board’s Review of OTC derivatives market reforms (2017): http://www.fsb.org/wp-content/uploads/P290617-1.pdf.
ii Trading venue is defined under MiFID II/MiFIR as a regulated market, multilateral trading facility, organised trading facility or equivalent third-country venue.
iii In order to determine whether the transparency and transaction reporting requirements apply, firms subject to MiFID II are required to assess whether derivative contracts are considered to be “traded on a trading venue” (ToTV), regardless of whether the transaction was concluded on a trading venue or over the counter (OTC). In its May 2017 Opinion on OTC derivatives traded on a trading venue, ESMA opined that OTC derivatives sharing the same reference data details as derivatives for which trading venues submitted reference data are considered to be ToTV.
iv At the end of last year, we explored how capital markets participants can respond strategically to using and reporting data in 2018.
v ESMA 2018 Supervisory Convergence Work Programme: https://www.esma.europa.eu/sites/default/files/library/esma42-114-540_2018_supervisory_convergence_work_programme.pdf.
vi ESMA 2018 Supervisory Convergence Work Programme: https://www.esma.europa.eu/sites/default/files/library/esma42-114-540_2018_supervisory_convergence_work_programme.pdf.
vii FCA Business Plan 2018/19: https://www.fca.org.uk/publication/business-plans/business-plan-2018-19.pdf