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Equity

Margin rules joke will bring a punchline in the face for ESMA

Buried in a hay bale of legal documentation last week, the European Union’s final draft of margin rules for uncleared swaps contained a joke that is sure to needle major banks. The question is whether anyone, including regulators, will still be able to smile at it when the September 1 deadline passes.

On almost every page of the final draft regulatory technical standards (RTS) put out by the European Securities and Markets Authority (aided by the European Banking Authority and the European Insurance and Occupational Pensions Authority) there are numerous changes from the second consultation paper the joint regulators put out last summer.

But despite the nine months of redrafting, one section remains conspicuously unchanged. Under the heading “phase-in of the requirements”, ESMA still offers the cheery guidance that “the RTS propose that the requirements will enter into force on September 1, 2016, giving counterparties subject to these requirements time to prepare for the implementation”.

Less than six months now remain for the preparation – minus whatever time one allows for the European Commission and European Parliament to authorise the final rules. Anyone who has even heard of Europe knows that this is an impossible deadline.

An impossible deadline, moreover, for a monumental shift in how the derivatives market is collateralised. And an impossible deadline caused by ESMA's slow drafting.

Big banks, who will be hit first by the regulations on that date, may not appreciate the joke. But lawyers permitted themselves a nervous chuckle at the dark humour of the moment, with one partner at a big-name firm saying that the time frame was “frankly laughable”.

There has been a stay of execution on equity options and FX forwards, which will be ‘phased-in’ to the margin rules over a longer period. 

But other equity classes, such as swaps and forwards, will still be caught by the September 1 deadline, while contracts for commodity derivatives, as well as typically non-cleared products such as single name credit default swaps, will also have to comply from that date.

That entails mountains of work for banks to get credit support annexes and collateral support units in order. Try they must, because they can hardly protest that they didn't see this coming. But with the best will in the world, banks still look desperately short of time to meet all of the ESMA mandate.

The joke thus hinges on a very serious question for regulators: what do they do when a whole industry falls short of the requirements they have set? 

It is highly unlikely that they are prepared to answer that question now to banks, as to do so would no doubt have counterproductive effects. But they are going to have to come up with an answer for themselves, if they haven’t done so already.

In the US, regulators have a tried and tested procedure that suits their purposes: set impossible deadlines for market participants, but then send ‘letters of no action’ when they fail to meet them.

Europe does not have ‘letters of no action’ unfortunately. A roughly equivalent approach was taken with Article 55 compliance under the EU Bank Recovery and Resolution Directive last year, say lawyers, but that was a single regulator. Getting EU-wide leniency on regulation is a much tougher task and would be without precedent.

Europe’s regulators may have to face up to the facts though. They are taking the derivatives market itself into completely new territory. If they don’t find some flexibility to ease the transition then the joke could end up being on them.

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