In January, MiFID II was brought into effect across Europe. The updated Markets in Financial Instruments Directive, which contains over 1.4 million paragraphs of rules and regulations for the financial sector, has changed how firms do business on a daily basis. Though it’s likely to take the sector years to fully realise the changes of MiFID II, firms who do not make a dedicated move towards compliance face a real risk of falling behind.
With MiFID II impacting everything from market structure to investor behaviour, there’s an incredible opportunity available for firms who can achieve compliance quickly. Getting the right processes and systems in place to handle MiFID II’s reporting measures – notably trade, transaction and OTC derivatives reporting – and record keeping will prevent firms from losing valuable data and falling foul of regulators at a later date.
The changes under MiFID II
While MiFID I, the original directive, focused primarily on harmonising regulation across European equity markets, the sizeable scope of MiFID II will affect a broad range of financial instruments. Most notably, with the introduction of OTC derivatives regulation and reporting.
The lack of regulation around the OTC market is frequently cited as one the problems that led to the worldwide financial crash in 2007-8. One regulator placed the market “at the heart” of the crisis, while another article referred to OTC derivatives as “the real cause”.
Under MiFID II, there’s a focus specifically on trading derivatives on venue. This will bring transparency to OTC trading, which has traditionally been conducted by two parties without any supervision. This transparency should provide better information on prices, force contracts to be standardised and reduce systemic risk for investors and regulators alike.
With an extensive transaction reporting system in place – designed to provide regulators with the information they need to monitor and detect market abuse – firms will be required to report much more information about their derivative transactions.
Introducing ISINs to OTC derivatives reporting
Since an outline to MiFID II was first announced, finding a comprehensive product identifier for OTC derivatives has been a thorny issue. In September 2015, EU regulators issued a requirement of ISINs (International Securities Identification Number), a coder that identifies a particular security.
The ISIN aligns with many of the MiFID II goals – it helps to improve transparency and clarity on price and volume in the financial markets, and it’s universally recognised. ISIN codes are made up of 12 characters, both letters and numbers. The code will primarily feature the country the company is based in and a random computer-generated complex formula, which prevents counterfeiting and forgery – another key part in regulators’ fight against market abuse.
OTC derivatives reporting measures
To be compliant with reporting measures, firms are now required to publish the details of their trades to an Approved Publication Arrangement (APA). MiFID II requires trades to be reported as soon as possible, with a limit of 15 minutes when dealing with off-venue (OTC) in bonds, structured finance and derivative products.
MiFID II transparency requirements will affect investment firms carrying on transactions outside of trading venues, if the instrument is ‘traded on a trading venue’ (also known as TOTV). To complicate OTC derivatives reporting, however, it might not always be clear whether the instrument has been TOTV. For example, it’s hard to know whether than OTC derivative is TOTV when it doesn’t have an issuer and it’s less standardised.
The challenges firms face
There are several challenges that financial firms face under new OTC derivatives reporting measures.
The greatest issue is the enormous amount of documentation required under MiFID II. Firms aren’t just required to aim for regulatory compliance; they’re also expected to analyse, understand and mitigate their exposure to market abuse and risk. For smaller firms in particular, a sizeable operational challenge lies ahead.
Complying with stringent pre and post-trade requirements (many of which are time-sensitive) might be achievable in the day-to-day, but MiFID II’s changes to OTC derivatives reporting risks create an avalanche of work. Since derivatives are now regulated, they’re likely to be viewed as a less risky option – increasing the overall use of derivatives, and therefore the volume of trades. During busy periods or market turbulence, firms will still need to record complex details like where and when the trades are logged, and ensure their method of reporting is consistent with industry-wide standards.
As MiFID II states,
“Trading venues should ensure their trading systems are resilient and properly tested to deal with increased order flows or market stresses, and that circuit breakers are in place on trading venues to temporarily halt trading or constrain it if there are sudden unexpected price movements.”
To be compliant with new reporting measures, it’s crucial that your firm has the systems in place to handle large quantities of data at once. With data quality in OTC typically much lower, MiFID II marks the start of a concentrated effort to ensure OTC derivatives reporting data is more consistent and reliable for the future of finance.
Keep on top of regulatory reporting with eflow
The introduction of OTC derivatives reporting sounds daunting, but it’s a great opportunity to make improvements to out-of-date processes and legacy technology at your firm. By optimising your analytical capabilities, you can make the most of a market with higher quality and more consistent data, and refine your client service.
Eflow is a market-leading provider of regulatory compliance solutions. From regulatory reporting and MiFID II record keeping to best execution and preventative market abuse measures, eflow’s solutions are designed to fit seamlessly into your firm’s processes. They combine the benefits of a comprehensive, off-the-shelf solution with flexibility of something that’s custom-built. Best of all, they’re continually updated to reflect the latest regulations, so you can focus on driving your business forward.
To find out more about the changes to OTC derivatives reporting, the latest EU regulations and how eflow solutions can help your firm with compliance, get in touch with us today.