US and EU regulators have promised to keep working toward mutual recognition of each other’s derivative clearing houses, but there is an ideological gap to bridge.

What’s happening?

Shortly before they were due to enter force in June 2015, the European Commission postponed for another six months new rules on the capital that banks must hold against their exposure to derivatives central clearing counterparties (CCPs). This follows an earlier six-month delay at the end of 2014. The postponement is needed because the EU and US authorities have not yet agreed to recognise each other’s CCP regulatory regimes.

Without such an agreement, EU banks would face a prohibitively high capital charge on any trades cleared through US CCPs. European commissioner for financial services Jonathan Hill and US Commodity Futures Trading Commission (CFTC) chairman Timothy Massad promised in early May a deal on this vital piece of cross-border regulatory coordination “by the summer”.

Marginal differences?

How large are the differences? European CCPs require members to post margin to cover two days’ potential losses, whereas US CCPs require only a one-day margin. In a hearing at the European Parliament in May, Mr Massad recognised that “all other things being equal”, the two-day margin rules require 41% more margin. European market participants certainly believe business might migrate to US CCPs if they are deemed equivalent with the current margin requirements.

But the equation is not that simple, because the US requires margin to be posted on a gross basis, whereas CCP members in Europe can net client exposures. Mr Massad said the CFTC had studied the nine largest clearing members at a US CCP, using actual data for a seven-day period, and calculated what the two-day net and one-day gross requirements meant in practice.

“What we found was that the total amount of customer margin under one-day gross was as high as 421% of the amount under two-day net, and was never less than 160% of that amount,” said Mr Massad.

European regulators led by the Bank of England apparently made a recent attempt to provide their own analysis, but this does not seem to have moved the debate forward. Market participants fear that the divide is partly political, tied up with broader questions around regulatory deference.

“The EU continues to hold up the US equivalence determination over the single issue of differing initial margining standards for clearing houses. By contrast, the European Commission recently granted 'equivalent' status to several jurisdictions in Asia, including Singapore, which has the same margin regime as the US,” Terrence Duffy, the president of the CME Group, said in testimony to the US Senate in May 2015.

However, European institutions are also uncomfortable with the US approach, which is criticised for not offering full reciprocation to EU institutions.

Reg rage - exasperation

“There is a sense of unease in Europe about the CFTC regime under which non-US CCPs must register as a designated clearing organisation in the US to provide clearing to US persons. That is in quite stark contrast to the European concept of recognition, under which the EU regulator is saying we will defer regulation of you to your home regulator if the US regime is deemed equivalent,” says Matthew Dening, a partner in the derivatives group at law firm Sidley Austin in the UK.

Honest broker?

At its board meeting in June, the International Organisation of Securities Commissions (Iosco) focused on CCP resilience as one of its key agenda items. Iosco chairman Greg Medcraft, who heads the Australian Securities and Investments Commission, might be able to play the role of neutral mediator between the US and EU.

“We need to educate, to explain, to build trust, to show the market that we are responding to concerns. All regulators acknowledge that clearing houses are systemic institutions, but they are designed not to fail, and there are powerful tools available to cope with stress scenarios,” he says.

What’s the cost of failure?

So far, in addition to the 16 registered EU CCPs, 10 foreign clearing houses have been recognised by the European Commission. Another 31 are awaiting a decision, most of them from the US. Andrea More of BNY Mellon’s collateral management team says clearing is already relatively bifurcated between the US and EU by its nature, and any failure to agree on CCP equivalence should not have a dramatic immediate impact.

“What we do not know is whether, when you combine this with the new margin rules for uncleared derivatives and the start of quantitative easing in the eurozone, there could be a collateral squeeze at some point in the future,” she says.

But other market participants are much less sanguine. Kenneth Kopelman, a partner in the derivatives practice at Sidley Austin in New York, says it would be “absurd” for the two most developed derivatives markets in the world not to recognise each other’s clearing house regimes.

“While market participants have started to get used to bifurcated liquidity, that does not mean it is healthy for the markets; regulators do not think it is a positive development. A fundamental principle of global derivative markets is to allow participants to trade and transfer risk in a portable way,” says Mr Kopelman.

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