ESMA writes off German regulator BaFIN as useless in massive tirade

Europe’s top regulatory body has issued a stinging indictment of the German financial supervisory regime which allowed bankrupt payment processor Wirecard to hoodwink investors for years.

It was always relatively obvious to those in major capital markets regions that Germany’s arrogant regulatory authority BaFIN, which requires all OTC firms to lodge client funds with German banks only, and had the audacity a few years ago to infer that a ‘latency floor’ would be enforced on FX brokers making their execution slower in order to level the playing field – ie thwart more efficient OTC firms to allow the large, old fashioned Frankfurt-based venues to keep their stronghold, is, not to put a finer point on it, ruddy useless.

BaFIN is regarded by many as one of the most recalcitrant and difficult organizations to operate under, and whose rules and imposed obstacles favor neither capital markets entities or their clients.

During the run up to the exit from the European Union of Great Britain, and during the absurd attempts by Frankfurt to merge Deutsche Boerse with London Stock Exchange – something FinanceFeeds stated from the outset would never happen – in order to try to encourage derivatives trading into Germany from London, a feat that would never be possible without political coercion because Germany cannot hold a candle to the UK when it comes to any form of expertise, infrastructure or market presence, attempts were made to take clearing to Europe, which of course failed, and here we are today with very few brokers operating under the BaFIN regime.

ESMA, itself a highly bureaucratic organization which implemented the MiFID II infrastructure directive and has the responsibility of overseeing regulatory adherence across all of the European Union’s member states, has today absolutely lambasted BaFIN, using almost expletive terminology.

The report by the European Securities and Markets Authority (Esma), identifies a number of “deficiencies, inefficiencies and legal and procedural impediments” in the two-tier German supervisory system, which splits responsibilities for enforcement between BaFin and the Financial Reporting Enforcement Panel (FREP).

Problem areas highlighted include the independence of BaFin from issuers and government, including “a heightened risk of influence by the Ministry of Finance” given the frequency and detail of reporting by BaFin before actions were taken.

Wirecard was a rising blue chip star before its collapse following the discovery of a gaping €1.9 billion hole in its balance sheet and regulatory bodies appeared at times to be more interested in defending the firm against a rising tide of allegations rather than dig deeper into its financial accounts. Esma says Frep’s examination procedures of Wirecard financial reports did not appropriately address areas material to the business of Wirecard, nor the media and whistle-blowing allegations against the firm.

Equally, a lack of information about Wirecard’s employees’ shareholdings was found to raise doubts on the robustness of BaFin’s internal control system regarding conflicts of interest of its employees vis-à-vis issuers

Steven Maijoor, Esma chair, says: “The Wirecard case has once again highlighted that high-quality financial reporting is essential for maintaining investor trust in capital markets, and the need to have consistent and effective enforcement of that reporting across the European Union.”

“Today’s report identifies deficiencies in the supervision and enforcement of Wirecard’s financial reporting. The report’s recommendations can contribute to the review of the German regime for supervision and enforcement.”

The outcome is likely to lead to an overhaul of the German supervisory regime to address the limitations in the two teir reporting system and the respective roles of BaFin and Frep.

That is for sure.

We have seen the behavior toward the derivatives and electronic trading industry emanating from Germany’s socialist government before.

Aspirations of control, but no means of competing.

Underpinning the entire combined cognitive prowess of London’s senior executives is a massive and finely honed technological infrastructure that ranges from hosting (Equinix LD4 being one of the largest electronic trading data center locations in the world) to order routing systems, liquidity management and in-house developed interbank and institutional trading systems that are supported by hundreds of developers and engineers per bank.

Europe does not have this in any shape or form, and before any dissenters seek to present Deutsche Bank as Frankfurt’s equivalent to Canary Wharf’s institutions, it is worth bearing in mind that Deutsche Bank conducts no electronic financial markets business whatsoever from Frankfurt, instead doing so from London, which is at odds with the all-controlling political stance of the socialist government of its host nation, obviously because business efficiency is more important than post-war socialist-progressive nationalist aspirations.

Even the European Central Bank attempted to get in on the cronyism. The sponsor of defunct EU member states which operate their treasury with the aplomb of a casino member with an addictive personality, absurdly inferred that the European Union’s hopes of bringing London’s financial markets sector to Frankfurt are impinged by approximately 8,000 miles of fiber optic cables which emerge from the seas around the UK at locations such as Crooklets Beach and Sennen Cove in Cornwall, and Highbridge in Somerset.

These cables carry data not only across the UK but to its continental neighbors, and whilst the European Central Bank is correct in suggesting that
the majority of Europe’s critical infrastructure for trading FX, as well as shares and derivatives, is clustered in a 30-mile radius around the City of London, and that regardless of the UK’s future, some of the industry’s biggest data center operators, which host banks and high-frequency traders’ IT equipment, have announced capacity increases this year to cope with rising demand from investors in both Asia and the US, the real reason is not just infrastructural, it is really around why that level of infrastructure exists only in Britain and not elsewhere in Europe.

Britain’s interbank sector is responsible for 49% of all global FX order flow at Tier 1 level, and consists of British and international banks based in London, marking out London as a true free market, with no controls on which banks and non-bank entities (Thomson Reuters, Currenex, Hotspot all have centers in London) operate there, yet that is the de facto center for electronic trading and always will be.

The ECB two years ago citing that the need to transfer data along fiber optic cables under the sea to and from London is a barrier to business is quite topsy-turvy. The actual reason is the reverse of that, simply that the reason that infrastructure is London-centric is because the entire global financial markets business is London-centric.

A clear (pardon the pun!) example here is that unlike equities, bonds or derivatives, the $1.7 trillion per day cash foreign exchange markets are not risk-managed through clearing houses but instead settled via London-based CLS International Bank.

The European Central Bank acknowledges that investors and companies have been empowered since the 1980s in London’s financial markets, as Britain began laying submarine fiber optic cables in the 1980s which now carry the majority of internet traffic.

Combine this with London’s Square Mile providing 19% of all tax receipts received by the European Union from just 0.0009% of the workforce of the European Union, a £176 billion value per year in revenues to the British economy and a trade surplus of £72 billion, and freedom to do business with the major financial centers of the world in the Far West and the Far East, this is one city which will never be supplanted by any faltering relic with aspirations of dividing and conquering.

At a similar time, Deutsche Boerse had plans to move the interbank and institutional clearing of FX to Germany from its absolute global heartland, Central London.

There are two potential responses to such a preposterous presumption, the first being to disregard it and banish it from memory, the second being to consider it an attempt at humor, intended by the kind gentleman of Fleet Street to brighten up the daily commute on an autumnal Monday morning.

Eurex, which is a Frankfurt-based clearing house owned by Deutsche Boerse, revealed its program to award its largest customers a share of its revenues, which has been construed by the pro-Europe mainstream publications in London as an attempt to incentivize large institutions to conduct their clearing in mainland Europe rather than in London.

In a statement three years ago, Eurex Clearing said its 10 most active participants would be eligible for a “significant share” of the returns from its multi-currency interest rate swap offering, as well as being offered seats on its board.

Deutsche Boerse has boldly claimed that Bank of America Merrill Lynch, Citigroup, Commerzbank, Deutsche Bank, JP Morgan and Morgan Stanley have all signed up to the program, adding to the existing 200 clients which Deutsche Boerse claims Eurex currently has on board.

Indeed, these are major Tier 1 FX dealing banks, and yes they may well have signed up to the program, but that absolutely does not indicate a priority to clear all their trades in Germany.

No Tier 1 bank would even consider doing that, and LCH Clearnet’s firm, London-based OTC FX clearing customer base will remain absolutely undiminished.

“This market-led initiative will benefit clients and the broader market place through greater choice and competition, improved price transparency as well as reduced concentration risk,” said Eric Mueller, Eurex’s chief executive.

Competition is not fostered by offering conflicting ownership stakes in clearing houses which are located far from the mainstay of interbank dealing and have no place in this industry’s global topography or infrastructural considerations.

The impending MiFID II rulings, set forth by pan-European regulatory authority ESMA require all venues, Deutsche Boerse being one of them, to report their trades as Regulated Marketplaces (RM), and will ensure that favorable advantages such as the sharing of the revenues of a trading venue with its participants, or offering shares in an RM to its customers are not permitted, as it creates the possibility of not providing the same terms to each participant, thus is not able to operate as an impartial centralized marketplace or counterparty.

That aside, Eurex already handles the vast majority of continental European trade clearing, yet is absolutely insignificant when compared to LCH.Clearnet’s clearing volumes in London.

Deutsche Boerse is well aware of this, so realizes that the string it has in its bow is an ability to lobby the European Cental Bank to ensure Euro clearing can be moved to Germany, this ideology being partly down to an escalating war between London and the European Union over euro clearing, with the City of London currently handling over 90% of Euro clearing.

Looking at the history of the failed merger between London Stock Exchange and Deutsche Boerse, it was clear that clearing dominance was part of Frankfurt’s agenda.

FinanceFeeds has been privy to information during the course of the proposals to merge the two venues that as a result of research by the European Commission, a merger would create the world’s largest margin pool with a value of 150 billion euros, therefore could impede competition for smaller trading venues that rely on LCH.Clearnet as well as other firms that offer similar collateral settlement services.

Germany. The non-entity that wants complete power

On that basis, London Stock Exchange’s response was to make a quick attempt to sell LCH SA in order to address proactively any anti-trust concerns. LCH Group which holds the European subsidiary LCH SA is 57% owned by the London Stock Exchange, with the remainder being owned by other users of the service.

It is ironic that the concerns of Lord Myners and other senior London officials with lifelong careers in the exchange traded derivatives sector in the largest financial center in the world were ignored by Germany, and that it has taken a report by the anti-business and staunch socialist European Commission whose interests are anti-British to stifle a potentially harmful merger which would have placed the control one of London’s fine institutions in Frankfurt, which is absolutely nowhere on the world’s financial markets and electronic trading stage.

The desperation that had now come about by the end of last year had been sensed by Euronext, which was one of the key suitors for the purchase of LCH SA, for which London Stock Exchange wants £430 million, and has to sell it in order to put paid to the investigation into any potential anti-competitive nature of the proposed deal, and quite frankly to just get on with it.

In late October last year, JPMorgan Cazenove was enlisted to oversee the sale of LCH SA, and all looked set to head to market and find a suitable acquirer, with Euronext being in the lead because it contributes around half of the revenue of LCH SA in clearing business from France, Holland, Portugal and Belgium.

Euronext appeared at the time to realize its position of strength in that it is strategically and operationally the most suitable acquiring party, and the shortlist of alternatives that would buy LCH SA is dwindling, however, Euronext made it clear that it would not pay one penny for LCH SA. FinanceFeeds held the opinion at the time that this in itself represented  a potential cartel in that clearing across all electronic trading via these two entities will become intertwined.

Therefore, even if that deal had gone ahead and was not a cash transaction, it would not matter if LCH SA was given to Euronext for free, as it would remove the one obstacle that is in the way of London Stock Exchange and Deutsche Boerse creating a massive margin pool whilst their perceived moves toward lobbying the FCA to restrict the core business activities of OTC participants makes for an effortless sweep in which the entire business can be moved to their books.

Deutsche Boerse has had OTC FX in its sights for some time, one example being the acquisition by Deutsche Boerse in July 2015 of FX trading platform 360T for $796 million.

Further examples of this have been demonstrated, some dating back several years. Back in 2011, Deutsche Boerse took a minority stake in British FX technology solutions provider Digital Vega which was a technology vendor to buyside and sellside firms in the OTC derivatives sector.

At that time, the idea was to increase Deutsche Boerse’s positioning in the provision of pre-trade price transparency in the derivatives area for institutional investors and taking an initial footprint in the FX derivatives space. An investment agreement was signed in February this year, whereby Deutsche Börse would pay a US dollar amount in the single digit million range.

Thus, this interest is quite clearly part of the overall strategy, and with the sale of LCH SA to one Euronext which serves the purpose of removing the EU concerns about monopolies, yet serves to empower the listed derivatives industry just as much as if it was retained, the strategy is laid out for the year ahead.

Several politicians in the state of Hesse, where Deutsche Boerse is based, have continually refused to accept anything other than moving the headquarters of what would have been a newly merged entity to Frankfurt, and Thomas Schaefer, finance minister in Hesse, recently said it was “crystal clear” after the UK Brexit vote that this HQ should be in Frankfurt.

A less than credible venue would be one located in Frankfurt rather than Paternoster Square, in terms of infrastructure, participation in institutional financial markets globally, and in terms of talent and alignment with key venues in Asia and North America. Quite simply, central Europe is a backwater by comparison, and hampered by bureaucracy, debt and lack of dynamism.

Baron Paul Myners CBE, who served as Financial Services Secretary to the Treasury between October 2008 and May 2010 under the Labor government of the time and has several senior executive positions behind him which were within large institutions including NatWest and RBS, as well as Lord Rothschild’s RIT Capital Partners where he serves as a board member since August 2010, has a vested interest in the merger, as he was appointed Chair of Governors at the London Stock Exchange in 2014.

In particular, Lord Myners, along with senior regulators in London, had concerns all throughout the negotiation process relating to how clearing operations could have been expanded across both exchanges.

According to laws in America and Europe, notably the Dodd-Frank Wall Street Reform Act and the EMIR (European Market Infrastructure Regulation), exchange-traded swap contracts must be cleared through specific electronic clearing houses, a process which engenders greater transparency and in the case of London Stock Exchange, its own subsidiary LCH.Clearnet is used for this purpose.

Undercaptalization

The case in point here is that nowadays, with large banks better capitalized, transactions are now being passed to institutions with very little capital at all therefore if large trades went wrong, there could be massive exposure, and as a result, a question mark hangs over the corporate governance of a new entity consisting of the London Stock Exchange and Deutsche Boerse with its head offices in two separate countries, which could lead to a shirking of responsibilities by British and European regulators, or a degree of buck-passing. Counterparty risk is, after all, a very important subject post SNB EURCHF peg removal.

The incumbent Chairman of the Treasury Select Committee Andrew Tyrie has been on the fence for some time regarding the potential British exit from the European Union, however he has been vocal regarding the standardized EU regulations across all industry sectors, stating that there is absolutely no reason to fear a standard EU ruling on all industry matters.

Indeed, Mr. Tyrie’s perspective on this matter is evident here, as he does not fear the potential difficulties which could arise from a merger between Britain and Germany’s flagship traditional exchanges, as it would appear to be manageable via standardized regulation.

However, if something does go awry and hand-wringing occurs between German and British regulators, then the effect on the Square Mile could be potentially vast. On this basis, politics should be left aside in favor of business acumen and suitability for purpose.

Seasoned London-based critics including prominent City journalist Alex Brummer, author of several books including “The Crunch” which looked closely at the reasons behind the 2008 credit crisis, have regaled indications from regulators that the sentiment within the offices of the authorities is that the merger proposals between London Stock Exchange and Deutsche Boerse have taken place over ‘cosy tea parties.’

London Stock Exchange acquired Borsa Italiana in 2007, during which time FinanceFeeds CEO Andrew Saks-McLeod spoke to then incumbent London Stock Exchange CFO Jonathan Howell at the London Stock Exchange’s then-new Paternoster Square headquarters.

At that time, Mr. Howell explained that, whilst time consuming, the acquisition was indeed that – a pure acquisition in which London Stock Exchange would become the owner of the Italian stock exchange, making its corporate decisions from London, a far easier way to manage a large entity, however with the uncertainty of future cross-border regulation in the advent of the Brexit, and an ‘equal’ merger between a British and German exchange, governance may well be somewhat different.

Lord Myners was certainly right about cronyism. However, cronyism and government bullying are tenets of socialist, anti-business regimes such as exists in Germany.

ESMA’s report this week shows the hypocrisy of BaFIN as well as its incompetence. BaFIN demands extreme parameters to be adhered to by market participants, which then have to pay one of the highest taxation rates in the world, and then proves ineffective at upholding standards.

Germany is known to be hugely expensive regarding setting up a business, and the tax rates are among the highest in the world. Therefore, it will be difficult for FX firms to turn up a sizeable profit after all the operational expenses, which forces FX brokers away from BaFIN. That in itself should be a reason to behave in a professional manner.

Every BaFin regulated Forex broker must have a minimum operating capital of €750,000, which may be increased by BaFIN according to the size of operations and the magnitude of the company, which is pretty standard, however brokers regulated under BaFIN should hold investor funds in segregated accounts, and must maintain accounts at Commerzbank and Deutsche Bank – a near bankrupt organization which has teetered on the brink of obscurity for several years and about which Germany’s government has publicly stated it will not bail out if Deutsche Bank collapses, and will simply let it sink, along with client funds.

These are also primary liquidity providers in the FX market, hence BaFIN’s interest in keeping all accounts with them – that is not a free market and is a borderline communist approach.

ESMA gets a bad rap in some respects, however this time it is laudable that it stood up against this inept regulatory authority.