Can the derivatives industry avoid a Brexit deathtrap?

Concern is still widespread in the derivatives industry that some of the world’s leading clearing houses – based in the UK – are approaching a ‘cliff edge’ on Brexit day, which is March 29, 2019.

Derivatives business is vital to the UK economy. Global trading in over-the-counter single-currency interest rate derivatives averaged $2700bn per day in April 2016, according to the Bank of International Settlements’ triennial central bank survey. Of this, $1200bn a day of trading took place in the US and $1180bn in the UK. By contrast, France claimed only $141bn a day of trading activity, and Germany only $31bn.

Since 2012, the European Market Infrastructure Regulation (Emir) has governed the operation of central counterparty clearing houses (CCPs) based in the EU. Following the UK’s decision to leave the bloc, the European Commission published proposals to amend Emir and introduce a two-tier system for classifying third-country CCPs in May 2017 (known as Emir 2.2). On March 30, 2019, the UK will become a third country.

Tier-one third-country CCPs that are not systemically important to the EU would continue to operate under the pre-existing Emir equivalence framework. Tier-two third-country CCPs that are systemically important would be subject to more strict regulatory requirements. These include compliance with the relevant EU prudential and central bank requirements, and providing the European Securities and Markets Authority (Esma) with all applicable information and to enable onsite inspections.

A threat to London?

However, the most controversial part of the proposals relates to tier-two plus third-country CCPs. It reads: “Depending on the significance of the third-country CCP’s activities for the EU and member states’ financial stability, a limited number of CCPs may be of such systemic importance that the requirements are deemed insufficient to mitigate the potential risks. In such instances, the commission, upon request by Esma and in agreement with the relevant central bank, can decide that a CCP will only be able to provide services in the union if it establishes itself in the EU.”

The last sentence was interpreted by many experts in the derivatives industry as a threat to force the London Clearing House (LCH), part of the London Stock Exchange, to move its euro business to the continent. LCH has about 90% of euro clearing business and processes up to €1000bn of notional deals in euro-denominated interest rate swaps every day.

The UK has two other important CCPs (both based in London): ICE Clear Europe and LME Clear. ICE Clear Europe provides clearing services for crude oil, interest rate, equity index, power, agricultural and energy derivatives, whereas LME Clear provides those services for the London Metal Exchange in all open outcry, electronic and telephone trades.

“We are very concerned because there is no clarity as to CCP recognition after Brexit,” says Ulrich Karl, head of clearing services at the International Swaps and Derivatives Association. “On Brexit day, clearing houses based in the UK will lose their authorised status under Emir. They must then apply for recognised status as third-country CCPs, and that process could take many months.

“The question is, what happens in the interim? At the moment, we do not know if there will be some kind of transitional agreement or temporary rules for a certain period or a cliff edge where UK CCPs lose their right to operate in the EU overnight. The industry must have clarity as soon as possible, at the latest at the beginning of the fourth quarter of 2018.”

Confusion reigns

Mr Karl says that if European firms do not have a clearer idea of what will happen in the post-Brexit world, they will have to begin the costly process of executing their contingency plans. This could involve migrating their euro clearing businesses to continental Europe. In cases where migration is possible, the process would be expensive, fraught with operational risk and could drive market fragmentation and systemic risk.

For many products, there are no alternative CCPs in the EU, and European firms will lose market access. SwapClear, part of the LCH, clears a total of 18 international currencies (deliverable) and three others (non-deliverable). In comparison, Frankfurt-based CCP Eurex Clearing clears only a total of nine currencies. Two European currencies – the Hungarian forint and the Czech koruna – are not even cleared by Eurex.

A better outcome, according to ISDA, would be to develop a model of supervisory cooperation that enables EU supervisors to exercise an appropriate and proportionate oversight of CCPs that provides clearing services in the EU.

In July, the UK government issued a draft statutory instrument regarding the temporary recognition of CCPs based in continental Europe. This regime would allow non-UK CCPs to continue to provide clearing services to UK firms for a period of up to three years while those CCPs apply for recognition in the UK. Many industry experts would like the European Commission to put in place a similar form of temporary recognition for CCPs based in the UK.

“Reciprocity is at the heart of the debate,” says Philip Whitehurst, head of rates service development at the LCH. “We are comfortable with the EU authorities having enhanced regulatory oversight of our business. We are already directly regulated in this way, for example in the US, by the Commodity Futures Trading Commission [CFTC].

“We support proposals for a direct registration model for CCPs operating within Emir 2.2. The Bank of England would likely remain the lead regulator for UK CCPs, but we would have to also comply with Esma’s rulebook, as we do today. It has been stated that a denial of recognition for UK CCPs post-Brexit would be very much a last resort. We support that approach, as one of the European Commission’s key objectives is to maintain the stability of the European and wider global financial system.”

Moving on

However, the commission is pushing the idea of the ‘equivalence’ of rules rather than ‘mutual recognition’. In April, Valdis Dombrovskis, European Commission vice-president responsible for financial services, gave a speech in which he said that equivalence was a pragmatic solution for the UK after Brexit.

“With Brexit, the UK will move away from the [Emir system],” he told the audience at the City Week event in London. “As a consequence, each side will have to set and implement its own rules to protect investors and ensure financial stability. In the words of chancellor of the exchequer Philip Hammond: ‘Neither side can be a simple rule-taker.’ But the EU has a long history of relying on the regulation and supervision of third countries, provided they achieve the same results as our own. We call this equivalence.

“Our risk-based approach and proportionate application of equivalence means that it can work for third countries with different levels of interaction with the EU financial system. The EU27 member states recently recognised this in a statement when discussing the future relationship with the UK. They also reiterated their support to build on and further improve equivalence. And that is what we are currently doing.”

But he added: “Equivalence decisions are and will remain unilateral and discretionary EU acts.” 

A possible deal

Under the equivalence concept, a central counterparty complying with the rules of a third country can be allowed to provide services to clearing members or trading venues established within the EU. Currently, the EU applies equivalence to central counterparties in 15 non-EU jurisdictions, including since 2016 the US.

Leaders of the derivatives industry believe that the idea of ‘improved’ or ‘enhanced’ equivalence could result in the UK getting a ‘bespoke’ deal with the commission. It is understood that the UK and the commission have agreed in principle a ‘standstill’ transition deal – under which the regulation of CCPs will remain pretty much the same – from Brexit day in March 2019 to the end of 2020, but it will not be ratified by the UK government and the EU until October this year or later.

The main bone of contention with the equivalence concept in relation to CCPs is that the UK would not have a future say in the EU’s regulatory or supervisory decisions, because the EU would not be prepared to delegate its responsibility in order to ensure the financial stability of its region.

“CCPs lie at the heart of the global and UK financial system and provide the infrastructure that allows the financial system to function in an orderly manner,” says David Bailey, executive director of financial market infrastructure at the Bank of England. “Well-functioning CCPs are crucial to the resilience of the UK financial system. The government has laid legislation to permit the Bank of England to temporarily recognise third-country CCPs for an initial three-year period following Brexit, and we have also outlined the process for full recognition. It is for the EU authorities to confirm their process for recognising UK-based CCPs after Brexit. The Bank of England has been working with UK-based CCPs on their Brexit contingency plans.”

US opposition

The Emir 2.2 proposals infuriated US regulators because they believed they had already reached an understanding with the EU about the supervision of US-based CCPs. CFTC commissioner Brian Quintenz told an audience in Florida in March: “In the proposed legislation, the European Commission is unilaterally abandoning the ‘recognition conditions’ set forth in the 2016 equivalence agreement. While Brexit presents significant challenges to the EU, it would be foolish for the EU to react by reneging on its agreement with the CFTC, the regulator of the world’s largest derivatives market. Yet that is exactly what the EU would be doing.

“The European Commission’s proposal is unacceptable to the CFTC. The entire US government is steadfast in its opposition to the commission’s proposal.”

Azad Ali, financial services regulatory partner at law firm Fieldfisher, says: “The commission’s plans are anathema to US regulators. Enhanced supervision proposals would be seen as encroaching on US sovereignty. They are premised on regulators in different countries having a high degree of trust in one another over and above current levels of regulatory co-operation.

“There is a risk that the EU’s approach could lead to ‘siloing’, in which euro interest rate swaps could only be cleared by EU clearing houses and US dollar swaps only cleared by US clearing houses.”

CCPs are backed by a series of capital buffers (in the form of initial margins, default funds, reserves and equity) and a risk-sharing arrangement among CCP members. Consequently, CCPs are deemed to be low-risk counterparties and, in this way, benefit from reduced regulatory risk capital charges.

The removal of current netting arrangements, as a result of the relocation of euro-denominated swaps to the eurozone, would increase initial margin costs for EU members by about 30% (some $5bn a year), according to the London Stock Exchange. Experts say that EU members would be even worse off than the rest of the world because their share of the market would have a smaller liquidity pool. Broker costs – which are ultimately felt by the end investor – would rise.

Continental European firms such as Société Générale and Deutsche Bank would not be able to conduct any swaps business cleared by LCH, for example, which would be devastating for those banks. 

Issues of scale

“London is arguably the leading financial centre for over-the-counter derivatives clearing in the world,” says Brian McDonnell, a partner at law firm Addleshaw Goddard. “Forcing banks to clear products through an EU-based CCP would increase costs both because of reduced netting and collateral efficiencies, and the increased risk related to doing business with smaller EU CCPs. These cost increases would be felt especially by European banks.”

Bill Stenning, managing director for clearing and regulatory and strategic affairs at Société Générale, adds: “Clearing is a scale business. This makes it difficult to relocate only one part of a CCP such as its euro clearing business. Often euros are only one part of a clearing house’s portfolio; it can also clear US dollars, sterling and the yen among others. This multi-currency clearing leads to many benefits and reduces both risks and costs.

“We are very sympathetic to the EU’s wish to have more oversight over euro clearing. We would encourage mutual recognition between the Bank of England and the European authorities during any transition period while a longer term solution is developed that provides for the necessary enhanced supervision and oversight.”

The European authorities have for a number of years been attempting to move the euro clearing business to the continent. In March 2015, the UK won a landmark legal battle against the European Central Bank over its plans to require big clearing houses to decamp to the eurozone. The EU general court found the bank “does not have the competence necessary to regulate the activity of securities clearing systems” and so cannot force operators to be eurozone-based when handling significant euro-denominated business.

The question of whether the EU recognises UK-based clearing houses after March 29, 2019, has become mired in the wider politics of Brexit. A ‘transitional agreement’ in which the status quo would last until the end of 2020 is now dependent on such matters as what happens at the Irish border. The derivatives industry is hoping that all the brinksmanship around Brexit ends soon, so that greater clarity will emerge about how CCPs will be supervised in a post-Brexit world.