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CESR Elaborates on OTC Derivatives Identifiers for Transaction Reporting

The Committee of European Securities Regulators (CESR) has published a consultation paper recommending the adoption a set of identifiers and classifications for OTC derivatives for the purpose of including those instruments in the exchange of transaction reports amongst CESR members. These reports are currently exchanged between regulatory authorities via an IT system, dubbed the Transaction Reporting Exchange Mechanism (Trem), which was introduced along with MiFID.

Trem has been in operation for around a year and a half and, in line with the current initiatives in the market to standardise derivatives, CESR has now decided to extend this system to cover these OTC instruments. The system was built based on the request from the MiFID level 2 regulation to organise the exchange of transaction reports amongst European financial regulators. CESR’s consultation paper is aimed at defining the framework for OTC derivatives in terms of this exchange.

Transaction reporting is used by national regulators to detect market abuse and maintain the integrity of their markets. MiFID granted these “competent authorities” the power and obligation to collect transaction reports on instruments admitted to trading on regulated markets. However, the OTC world is currently not properly covered by this legislation and CESR is therefore seeking to enshrine best practices for these markets covering instruments including: options, warrants, futures, contract for difference (CfD) and total return swap (TRS), spread bets, swaps, credit default swaps (CDS) and complex derivatives.

CESR indicates that it decided to go for a more comprehensive approach where derivatives that would not fall within plain vanilla general categories would still be reported under a common “complex derivatives” label. The boundaries between “plain vanilla” and “complex” derivatives will be further defined in harmonised guidelines, as well as other useful common standards for consistent collection of data between participating member states, it says.

The remit of this endeavour is to standardise the data that the regulators exchange regarding these instruments in terms of derivative types and instrument identifiers. CESR began the project in February this year with an industry consultation on the subject and the recent report is the culmination of its own work and the input from the market.

CESR notes that this is an incredibly difficult area in which to standardise data and thus it notes it must bear several things in mind: “This should be a high level classification, knowing that there are many sub­classes under an instrument type. The classification has to be reviewed frequently as the market changes quickly. There are a number of unclassified instruments that are too complex to be classified.”

Classifications within Trem are currently based on ISO 10962 but CESR notes that this code only covers two of the eight types of OTC derivatives instruments that the regulator wants to add. However, the Association of National Numbering Agencies (Anna) is currently working on a new version of this standard, which is due to be released at the end of this year and should cover these other instruments.

“Given the essence of the OTC derivatives, CESR thinks that it would be too burdensome for the investment firms creating an OTC derivative to require a National Numbering Agency to create a Classification of Financial Instruments (CFI) code for each contract. Therefore, the only option left would be to ask the investment firms to generate the code based on the standard,” says the report. “CESR concluded that requiring the investment firms to fill in the six letters of the CFI code would be a major burden and the costs implied would be greater than the benefit for the regulators. Implementing the full CFI code is too complex to implement for market participants solely for the purpose of transaction reporting.”

So, if a CFI code isn’t appropriate for the industry to maintain, what next? The regulator also dismisses the use of FpML for its purposes too, because it “does not fit to the needs of market surveillance by CESR members”. CESR’s solution is to create its own simple classification system based on the classification currently used by the UK Financial Services Authority (FSA) and Irish FSRA.

Like the derivatives ABCs, the system allocates one letter for each of the instrument categories: options as O, warrant as W, futures as F, CfD and TRS as D, spread bets as X, swaps other than CfDs, TRS and CDS as S, CDSs as Z, and complex derivatives as K. So that’s flashcards for regulators sorted then, but what about instrument identifiers?

Instruments in Trem are identified using the ISO 6166 (ISIN) standard or the Alternative Instrument Identifier (AII) for some derivative markets. However, the ISIN standard does not currently cover OTC derivative instruments and CESR has concluded that it would be too costly for the industry to adapt it to cover them.

CESR also reckons the AII is not appropriate as a method of identification due to the fact that it only uses six characteristics to identify instruments. It therefore contemplated adapting AII codes to add on an additional characteristic, bringing the number to seven, in order to accurately capture the identifiers of an OTC derivative.

CESR therefore proposes to add seven new elements to the usual fields exchanged in Trem: the ultimate underlying ISIN (the ISIN of the ultimate equity or bond instrument underlying the derivative); the underlying Instrument type (using the first letter of the CFI code for this purpose); the derivative type; the put/call identifier; the price multiplier; the strike price; and the expiration date. 

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