What you need to know
- Under European rules, known as European Market Infrastructure Regulation (EMIR), a temporary variation and initial margin exemption was originally provided for equity options. This exemption has already been extended several times and is now set to expire in January 2024. The primary reason for this exemption was to avoid market fragmentation. It was also provided to ensure a level playing field for EU market participants compared to other jurisdictions, such as the US, where equity options are permanently out of scope for margin requirements.
- Other jurisdictions, most notably the UK and Switzerland, also still benefit from a similar temporary exemption. In the UK, the industry expects the Prudential Regulation Authority (PRA) will consult on this topic over the summer.
- At the end of 2022, the European Commission (EC) released amendment proposals to EMIR (so-called EMIR3). The objective was to reduce dependency of EU market participants for EUR clearing on third country CCPs of systemic importance, and also to reflect on additional issues in the operation of EMIR more generally. This proposal is currently subject to the ordinary legislative procedure via the Council and the Parliament.
In the context of the on-going EMIR3 legislative process, on 5 June 2023, the EU Parliament released their first draft report, which is a prelude to defining their negotiation mandate. In this report, the Parliament proposes a measure to address the expiration of the current margin exemption for equity options.
What could happen if the current exemption ends?
If the equity options derogation is allowed to expire, EU market participants could be faced with greater costs associated with hedging activities than their US peers, by virtue of imposition of margin requirements. Similarly, US firms would likely be able to compete for business on more favorable pricing terms than EU banks and investment firms.
A margin requirement for equity options trading under EU rules could also inhibit trading between US and EU counterparties. US counterparties may be less willing to trade with EU counterparties given the terms associated with imposition of collateral requirements, especially initial margins.
Equity options are valuable tools for financial investors and other corporations to manage risk. The requirement to post margins on equity options supporting a specific investment or funding strategy may, in some instances, no longer make that hedge or even that investment or funding strategy viable.
The industry’s view
Within the financial industry, there is a strong consensus between buy and sell sides that this temporary exemption should be made permanent, or at the very least extended. This is to align primarily with US rules, as highlighted by the latest ISDA letter to EU authorities. This letter was cosigned by multiple trade associations working together to seek a resolution.
Until now, EU authorities and supervisors have been hesitant to provide a permanent exemption for several reasons. These include a potential financial stability risk, knowing margin rules for OTC derivatives were introduced in the wake of the 2008 global financial crisis. Such risk is seen as extremely limited for this transaction type, as highlighted by a recent Bank for International Settlements report. This report shows that volumes of equity options, which have a short maturity by nature, are marginal compared to the overall volumes of OTC derivatives already subject to margin rules. “The equity option margin exemption would avoid market fragmentation and supports the competitiveness of EU market participants in a market that, while commercially important to European liquidity providers, comprises a very small portion of global derivatives market activity,” commented Perrine Herrenschmidt, Senior Director, European Public Policy at ISDA.
The equity option margin exemption would avoid market fragmentation and supports the competitiveness of EU market participants in a market that, while commercially important to European liquidity providers, comprises a very small portion of global derivatives market activity.
Perrine Herrenschmidt, Senior Director, European Public Policy, ISDA
The step that could unlock a solution
Conscious the end of the latest exemption extension is fast approaching, the European Supervisory Authorities (ESAs), who own this exemption, sent a letter to the co-legislators stressing that the ongoing EMIR review must clarify this issue. While a permanent exemption, or at least an extension, was not initially proposed by the Commission in their EMIR3 draft, it is now being considered as part of the legislative process, by both the EU Council and the EU parliament.
The recent initiative from the Parliament to include an attempt for a durable solution to align with other major jurisdictions, could be supported shortly by the EU Council under the upcoming Spanish Presidency. “The clock is obviously ticking and relevant authorities must be aware that a solution is needed in a reasonable timeframe, to avoid market disruption and unnecessary and costly contingency measures,” commented Simon Laforet, Senior Officer in Public and Regulatory Affairs at BNP Paribas Global Markets.
The clock is obviously ticking and relevant authorities must be aware that a solution is needed in a reasonable timeframe, to avoid market disruption and unnecessary and costly contingency measures,
Simon Laforet, Senior Officer in Public and Regulatory Affairs, BNP Paribas Global Markets