LONDON New European Union rules designed to bring stability and clarity to opaque derivatives markets are sowing confusion among metals brokers, raising more questions than answers for clients and throwing the fate of smaller firms into doubt.
The bloc's European Market Infrastructure Regulation (EMIR) is a package of reforms drawn up in response to the global financial crisis, in which less regulated market conditions allowed contagion to spread quickly.
"EMIR is a rule book without totally defined rules," said Malcolm Freeman, chief executive of brokerage Kingdom Futures and a former trader with London Metal Exchange (LME) ring-dealing member INTL FCStone.
"Is it going to protect anybody? No. Will it stop rogue traders? No. So what's it for?"
The reforms state all derivatives transactions must be reported to a trade repository, introduce mandatory clearing for certain over-the-counter (OTC) derivatives and impose higher margin requirements on OTC derivatives that are not centrally cleared.
They apply to all European Union firms that buy or sell any form of derivative, including those on interest rates, foreign exchange, equities, credit risk and commodities, and apply indirectly to non-EU firms trading with European companies.
EMIR was adopted in 2012 but is being phased in gradually, with many of the most onerous rules taking effect this year.
Brokers on the 137-year-old LME feel squeezed by the new rules because they come at a time of ever-shrinking margins, with some commissions down to around 15 to 25 cents a tonne.
They also worry the exchange will raise its trading fees from next year, as Hong Kong Exchanges and Clearing, which also runs the Hong Kong bourse, struggles to justify the $2.2 billion it paid for the LME in 2012.
To cope with the burden of EMIR compliance, some brokerages are absorbing costs, others are passing them on to clients by charging a flat fee, while at least one is levying fees based on the volume of business its clients transact.
QUAGMIRE OF UNCERTAINTIES
As a reflection of the uncertainty surrounding EMIR, the EU's markets watchdog wrote to the European Commission earlier this month to seek clarification on the definition of a derivative, which varies across Europe.
The European Securities and Markets Authority (ESMA) sent the letter just two days after the requirement to report derivatives trades came into force on February 12.
Brokers are just as baffled as to how European regulators will use the reams of data to which they now have access to stop risky derivatives positions building up.
Michael Overlander, chief executive of leading LME brokerage Sucden Financial, said his firm had reported almost a million transactions in the week after the EU reporting requirements took effect, a time when the markets were quiet.
"Who knows what it's going to be like if the markets start to heat up," Overlander said. "It's an absolute quagmire of uncertainties."
A senior executive at another large LME brokerage said the firm had taken on new staff to ensure it complies with EMIR, while another said EMIR was distracting entire departments.
"We are hand-holding customers through the new regulations," the executive said. "People are calling multiple times to ask about what they have to report and which forms they need to fill in."
The United States introduced mandatory derivatives reporting in 2012, but last year a U.S. regulator said the data did not pick up the "London Whale" derivatives trades that cost JPMorgan Chase & Co over $6 billion in 2012.
The LME - the world's largest marketplace for industrial metals - said in written comments that while EMIR compliance would inevitably increase costs for members and their clients, the impact on liquidity was difficult to predict.
In September, it is set to launch its own clearing house, LME Clear, which members will be obliged to use.
MORE PAIN AHEAD
One possible outcome of the heightened regulatory scrutiny is that the pool of brokerages will shrink, meaning clients will have less choice and pay higher commissions.
"The problem is that EMIR is bound to favour the bigger institutions over the smaller ones, because economies of scale will make them better able to absorb costs," said Steven Spencer, managing director of LME brokerage Traderight.
But the biggest hurdles for LME brokers may be yet to come.
At some stage in the second half of this year, firms will have to clear centrally a range of OTC derivatives, and broker and client accounts must be segregated at the clearing house.
European regulators are yet to specify exactly when these rules will take effect, and ESMA is yet to decide which derivatives must be centrally cleared, adding to the confusion.
Brokers say this particular subset of rules will hurt liquidity and drive up costs for the hundreds of firms that use the LME to hedge their exposure to industrial metals prices.
Whereas traditionally brokerages have extended credit to clients at little or no cost, the account segregation rules will restrict them from doing so, meaning they will be likely to charge more for providing the same service.
"It's almost like EMIR wants to get rid of credit, make the market cash-settled," Kingdom Futures' Freeman said. "It will make being a traditional broker-dealer very difficult."