What’s changing with the MiFID II SI regime?
Effective September 2020, ESMA introduced the mandatory Systematic Internaliser (SI) regime for OTC Derivatives and Structured Products. Prior to September, the OTC Derivatives SI regime was voluntary – that is, firms could opt into the SI regime, which carries certain obligations with respect to price transparency and trade reporting.
In April, ESMA published the templates they will use when publishing the EU RTS 2 volumes. The templates include the list of asset classes and sub-asset classes, as well as the attributes to be used to define further sub-classes. ESMA sub-classes are very granular. As an example of a sub-class, ESMA will define a number of Time to Maturity (TTM) buckets and firms will be able to decide whether they will be SIs based not just on, for example, Fixed to Floating Euro Interest Rate Swaps, but also on TTM buckets – say, Fixed to Floating Euro IRS under 1 year.
On July 31st, ESMA published the total number of trades and total volume over the period of January through June 2020 for 5,896 different sub-classes of Derivatives. Based on these volumes, firms reaching a certain threshold will be mandated to be SIs – the same regime that is now in place for Equities and Fixed Income instruments.
Why is it complex?
In contrast to Equities and Fixed Income, which are well understood and have only sub-asset classes (for example, sub-asset classes are common stock, ETFs and depository receipts for Equities; sovereigns, corporates and convertibles for Fixed Income), the number of asset class/sub-asset class/sub-class combinations defined by RTS 2 for OTC Derivatives is extensive:
- 14 Derivatives & Structured Product asset classes
- 89 total Derivatives & Structured Products sub-asset classes
- Within sub-asset classes, there are 37 additional selection criteria – for example: Currency, Time to Maturity buckets and so on – that determine sub-classes. Within these criteria, there can be several domain values – for example, 7 for Energy, 3 for Settlement Type, more than a hundred Notional Currencies, 7 Interest Rate Term types. The sub-classification is exhaustive.
It’s important to note that ESMA has calculated volumes for only about half of the 5,896 possible Derivatives sub-classes as of September. That is still a big number, though. ESMA does recognise the challenges that firms will have in complying with the OTC Derivatives regime. *
The very granular nature of the derivatives regime means that firms can choose to take advantage of the granularity by deciding to become SIs for a narrowly-defined OTC Derivative sub-class. For example, firms may choose to be a SI in Energy futures and options, but not Agriculturals or Metals; or Equity Options and Equity Index Options, but not Volatilities; or, as in the example above, Fixed to Floating Euro IRS with less than 1 year to Maturity.
These complexities – and especially the granularity – will have important effects for all market participants.
What’s the effect on firms of these changes to the MiFID OTC Derivatives regime?
Every firm will want to assess its own position, but broadly, the primary effects of the changes will be:
Systematic Internalisers and Other Broker Dealers
The main concern here is the granularity of the internal decision to opt in to the SI regime and second, the likelihood of mandatory determination. Given the issues firms have seen with MiFID transparency in other asset classes, and the differential benefits to firms in terms of order flow, the decision to sign up (opt in) as a SI and at what level of granularity will likely be the most pressing concern.
Firms will also want to consider a number of operational issues with post-trade reporting determination.
For trade report determination, whether your firm must trade report is determined by whether your counterparty is a SI, or not.
Some firms have decided to make the trade reporting determination themselves. In this case, the introduction of the mandatory Derivatives regime means they will want to think about how best to manage the reporting waterfall logic, given the additional complexity presented by OTC Derivatives. Firms must map from their internal classification schemes to the ESMA templates and the SI Registry templates, which have some differences, in order to correctly execute their trade reporting responsibilities.
Other firms – perhaps the broad majority – have delegated the trade reporting task to their APAs. In these cases, the issue is whether your firm has a control framework in place, as regulators require, to make sure that there is no over- or under-reporting. Again, the granularity of the OTC regime makes this complex and the SI Registry is the essential tool for understanding SI status.
For asset managers and hedge funds, the complexities of the new OTC Derivatives regime mean that additional focus must be placed on broker selection, which becomes much more difficult. Buyside firms in almost all cases will want to trade only with SIs, so that they don’t need to build trade reporting infrastructure. This means they need to keep on top of which trading counterparties are SIs for which classes of Derivatives. In this instance, the SI Registry also gives some insight into where liquidity may cluster, within the many sub-classes.
What tools do I need to make sure I have the right controls in place?
Whether your firm is a SI, non-SI broker dealer, asset manager or hedge fund, understanding whether you or your counterparty is or is not a SI is paramount and, given the granularity introduced by the OTC Derivatives mandatory regime, complex. For SIs and non-SI broker dealers, the requirement is primarily driven by trade reporting. For asset managers and hedge funds, the need is getting on top of broker selection.
In all cases, the Systematic Internaliser Registry (SI Registry) is the essential tool for understanding SI status.
The SI Registry is a joint initiative between SmartStream RDU and the 6 MiFID APAs (Approved Publication Arrangements) - Bloomberg, Deutsche Boerse, NASDAQ OMX, TradeEcho, TradeWeb and TRAX. RDU works with all the APAs to provide a consolidated view of all Systematic Internalisers and the instruments (ISINs or groups of ISINs) for which they are SIs. There are more than 125 SIs participating in the Registry, with more firms expected to become SIs as the mandatory OTC Derivatives regime comes into force and matures.
Using the SI Registry, firms know with certainty whether their counterparty is a SI, or not.
How does the SI Registry API help simplify the task of OTC Derivatives trade reporting?
The SI Registry takes contributions from Systematic Internalisers in ISIN, Issuer and COFIA (EAMA’s Classes of Financial Instruments Approach) formats in order to distribute information about SIs and the specific instruments they offer for equities, fixed income and now, importantly, Derivatives.
Given that SIs will contribute their SI status for Derivatives at the class level, firms will face challenges mapping an ISIN to the applicable COFIA record(s). Firms must either figure out where to get the classification data for the ISIN, translate it into the SI Registry format and then look it up in the SI Registry file to find the applicable record(s) OR they can simply use the SI Registry API.
RDU’s API simplifies the identification of counterparty SI status. Aligning fully with the regulation, the API service allows a firm to enter a single identifying ISIN for a Derivative trade, which it then translates and communicates to the SI Registry, returning a list of relevant SIs for that ISIN (and COFIA class).
In some cases, the ISIN won’t be immediately available. For these scenarios, the API is able to take identifying fields provided by the firm and return the COFIA class as well as the SIs for that class.
How can I take advantage of the SI Registry to help manage the complexity of broker selection?
SmartStream RDU offers the SI Registry as files, and also through an easy to use API, which makes integration quick. The API is especially helpful for asset managers, hedge funds and smaller broker dealers: A simple request – sending the ISIN down to the API – returns the list of SIs for that ISIN.
* In their announcement, ESMA said this about the complexity of the OTC Derivatives implementation:
However, despite ESMA’s support to the industry, market participants made ESMA aware that a number of technical issues for the implementation and performance of the SI test for derivatives still exist independently from the availability of such templates (e.g. the fact that RTS 2 reference data is not publicly available makes it difficult to easily classify instruments for the SI test).
ESMA acknowledges the difficulties that market participants will have to face and is working to find feasible solutions to such problems. ESMA will continue to collaborate with market participants and plans on the technical side to include the classification of the instrument in FITRS and on the policy side to review Commission Delegated Regulation (EU) 2017/583 (RTS 2).
About The SmartStream Reference Data Utility (RDU)
The SmartStream Reference Data Utility (RDU) is a managed service that delivers complete, accurate and timely reference data for use in critical regulatory reporting, trade processing and risk management operations, dramatically simplifying and reducing un-necessary costs for financial institutions.
The RDU acts as a processing agent for its participants selected data sources - sourcing, validating and cross-referencing data using market best practices so that these processes do not need to be duplicated in every financial institution. An experienced global team, who operate under the compliance frameworks of their customers, deliver data that is fit-for-purpose, consistent and in a format that is specific to the financial institutions’ needs.