FCA Paper – Are small firms being locked out of the derivatives market?

The FCA has published a research paper analysing the impact of the introduction of EMIR variation margin requirements in 2017 and whether small firms were locked out of the derivative markets as a result.

In 2009 G20 leaders met in Pittsburgh to discuss the risks revealed by the 2007-8 financial crisis and to agree actions to prevent a recurrence. Part of the agreed remediation was to improve risk management in the over-the-counter (OTC) derivatives market to make the market more transparent.

In Europe, the EU’s response was to enact the European Market Infrastructure Regulation (EMIR) in 2012 which included a requirement for firms of all sizes, on either side of a derivatives transaction, to pay variation margin to cover adverse fluctuations in trading positions. The intention was to reduce the immediate market impact if a derivatives counterparty suddenly failed. Prior to the crisis the OTC market was opaque to regulators and central banks and EMIR was an attempt to make the market more transparent by requiring parties to report derivatives transactions.

The more detailed rules were not finalised until late 2016 and the implementation timescale was tight. Quite a few businesses, particularly smaller ones, felt that they were at risk of being temporarily locked out of derivatives markets if they were not able to meet the deadline.

FCA economists John Wu and Florian Schroeder have published a research paper to analyse whether EMIR had any material impact on the derivatives market at the time of implementation.

Wu and Schroeder first analysed activity levels around 4 th February 2017, when the rules took effect for the largest counterparties. Their expectation was that the largest firms would be well prepared and this was borne out as market activity stayed within normal levels around and after 4 th February.

Next, they analysed activity levels around 1st March when the rules took effect for all other counterparties. Their analysis showed a spike in trading activity immediately before 1st March, which suggested that some firms had traded ahead of this date to avoid any post-implementation issues. Importantly, though, their analysis did not show any material decrease in either the total number of trades or the notional amounts traded after the implementation date. They also analysed whether there was any drop in activity by small firms and, again, their analysis did not show any material decline in numbers.

Implementation is not yet complete and policy makers will need to continue monitoring the effects of EMIR on the market when new initial margin requirements come into force in September 2017.

The link to the full FCA Research Paper is here https://www.fca.org.uk/insight/are-small-firms-being-locked-out-derivatives-market