European Union plans to radically reshape derivatives and share trading lack clarity and fail to understand how banks operate, top trading firms said on Thursday.
The EU's executive, the European Commission, on Wednesday unveiled a draft law to update its securities rules, known as the Markets in Financial Instruments Directive (MiFID).
The draft includes a new category of platform, known as an organized trading facility (OTFs), and is designed to shine a light on the murky world of dark pools, also known as systematic internalizers, the private and anonymous trading venues owned by banks, and clarify how banks use client trades.
The regulators are creating a new category of OTF to split client business from prop (proprietary trading) business, but this is a grey area, said Simmy Grewal, an analyst at research house Aite Group.
If the bank is using its own capital to facilitate a client trade, can the resulting position be traded against another client? said Grewal.
The rules follow a pledge by world leaders that all standardized derivatives contracts currently traded between banks in the over-the-counter (OTC) or off-exchange markets should be traded electronically, where possible.
The aim is to make trading in the $600 trillion OTC derivatives markets safer and more transparent so that regulators can keep tabs on traders.
I want to put an end to the OTC and opacity, apart from some very specific and limited waivers, the draft law's author, EU Internal Market Commissioner Michel Barnier, told a news conference on Thursday.
ILLUMINATING DARK POOLS
Large brokers, such as Citi, Deutsche (DBKGn.DE), Morgan Stanley (MS.N) and UBS (UBSN.VX), look to match orders -- both their own and those of their clients -- privately in dark pools to avoid the added cost of using exchanges.
They argue that separating client orders from the broker's own proprietary flow makes no sense because many client orders are facilitated, or partly funded, by their brokers, so there cannot be a clear distinction.
The distinction between the OTFs and systematic internalizes, which effectively separates customers' orders from principal flow, is largely artificial, said Jack Vensel, the global head of wholesale services at Citigroup (C.N).
Broker trade body the Association for Financial Markets in Europe has called for a clear definition of OTFs that respects the differences and choice between trading venues.
The new rules are strict. Only ad hoc trading in shares, bonds and non-standardized derivatives will continue to be allowed to take place off a platform, the Commission said.
New global bank capital requirements rules being thrashed out by the Basel Committee will also make it punitive for banks to trade bilaterally and avoid using platforms like OTFs.
BROKERS AWAIT WAIVERS
Banks won't know the exact impact of OTFs until the Paris-based European Securities and Markets Authority (ESMA) finalizes measures to implement the new law, which may take one to two years.
The full transparency details have been delegated to ESMA, and we don't know what the precise definitions will be, said Andrew Bowley, head of electronic trading product management at Nomura (8604.T).
Industry officials say that without broad waivers it would be difficult to continue with bloc trades, for example.
ESMA will decide waivers by majority voting, making it impossible for Britain, the EU's biggest derivatives trading center, to wield a veto.
I want to ensure the waivers they benefit from are proportionate, justified and limited, Barnier said.
UK-based industry officials say ESMA will end up effectively controlling the wholesale market in Britain.
The United States has also approved a law to introduce swap execution facilities or SEFs for trading OTC derivatives. Like these venues, OTFs will also have to include third party liquidity, and stop being just a platform for bilateral trades.
Brokers want to be able to say who should be allowed to trade on an OTF. But exchanges argue there should be no discrimination, and they should be treated like bourses.