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Carrot or stick? That is the question that policy-makers in Brussels face as they put pen to paper on new laws that will seek to make EU clearing services more attractive and resilient. Patrick Mulholland reports.

In December, the European Commission (EC) set aside its hard-line rhetoric on what it sees as the bloc’s overreliance on London for euro-denominated derivatives clearing, in favour of a more measured approach. Under the proposals, banks will have to set up accounts with minimum volume levels at clearinghouses in Paris and Frankfurt, rather than shift trillions of euros of transactions across the channel in one fell swoop.

“The requirement does not imply that all clearing should be repatriated to the EU,” said the EC in a statement. “It covers only a portion of the relevant activities and does not forbid clearing in other jurisdictions.”

Previously, financial services commissioner Mairead McGuinness had called London’s control over derivatives clearing “a point of vulnerability” for the EU and likened the loosening of that grip to weaning the continent off Russian gas. It appears that the EU stance on this has shifted.

Banks are breathing a sigh of relief at the regulatory volte-face, but that uneasy truce may soon be broken as the EU decides on how to set those “minimum volume” levels.

Clearing quandary

Derivatives are financial contracts that draw their value from an underlying asset, with interest rate derivatives (IRDs) being by far the largest class in gross market value. Such contracts can be traded on a regulated exchange, a trading platform, or over-the-counter (OTC) between counterparties on tailor-made terms.

As of June 2021, the Bank for International Settlements (BIS) put the size of the global OTC derivatives market at $610tn, the bulk of which is cleared in London. This is particularly the case with euro-denominated IRDs, where 94% of traded notional securities are cleared through LCH, a London-based central counterparty (CCP).

Following the UK’s departure from the bloc, the EU stepped up its efforts to chip away at London’s dominant market position in the name of “financial stability”. In 2020, the EU revised its legal framework — the European Market Infrastructure Regulation (EMIR 2.2) — to include new provisions that give supervisory authorities discretionary powers to monitor “systemically important clearinghouses in third countries”. While similar provisions have been mirrored in the UK, British authorities have adopted a less strict regime compared to their continental peers, who have explored the possibility of labelling UK CCPs as being of “substantial systemic importance”. In effect, that would exclude those CCPs from clearing derivatives that the EU deems could threaten its financial stability.

It might be nice to have clearing in the EU, but the bloc doesn’t have a CCP that could really do that

Matthias Lehmann

The active account requirement is a direct response to a report published by the European Securities and Markets Authority (Esma) in January 2021, which investigated UK CCPs — LCH and ICE Clear Europe — but shied away from demanding a full relocation of clearing to the EU.

The report concluded that “the costs and risks of derecognising these services would outweigh the benefits to the EU at this time”.

“What Esma did was basically a balancing act,” explains Matthias Lehmann, who specialises in cross-border issues of financial law at the University of Vienna. “It might be very nice to have clearing in the EU, but at the moment the bloc doesn’t have a CCP that could really do that. And to cut itself off from Britain would really be economically disadvantageous for the EU.”

Instead, the report recommended that the EU introduce appropriate incentives to build up European CCPs and reduce exposure to UK clearing houses, as well as an expansion of Esma’s crisis management tools to include new “recovery and resolution” powers.

Market response

While the active account requirement does not set into motion the worst-case scenario of banks and dealers being “forced and cajoled” into shifting clearing activity to the EU, as initially feared by Bank of England governor Andrew Bailey, market participants are still nervous.

Meanwhile, the International Swaps and Derivatives Association (Isda), an international trade organisation, worries that the measures will be “harmful to EU capital markets”.

“We were not expecting the proposal for active account requirements to be as far reaching,” says Ulrich Karl, head of clearing services at Isda. He is urging the EC to provide “a robust cost-benefit analysis” of its proposals.

Much of the anxiety comes from the fact that the minimum volume levels are undefined. According to a policy paper from Isda, minimum levels based on notional values (the total underlying amount of derivatives trade) would only incentivise shorter duration trades — which tend to be larger — to shift to EU CCPs. Meanwhile, levels pegged to trade frequency would simply capture high trade counts with low risk, such as market-making businesses. And levels based on initial margin or standardised risk would incorporate some risk sensitivity, but are difficult to calculate.

Putting a number on minimum volume levels is crucial because it will determine the degree of market fragmentation and, of course, the increase in costs.

It is as if the EC has “chosen to leave a foot wedged in the door”, says Mr Lehmann, as whatever minimum requirement is set could subsequently be increased through secondary legislation.

“Esma is charged with ensuring that the minimum volume is set [by 2026] in such a way as to ensure that the UK CCPs will no longer be of substantial systemic importance for the EU,” he adds. “This is like a regulatory reduction of the significance of UK CCPs.”

“It is hard to see that any market participant will be enthusiastic about these developments,” says Damian Carolan, a partner at the law firm Allen & Overy. “The idea of a fairly arbitrary minimum amount of clearing which must be redirected to an EU CCP will increase costs, reduce choice and complicate business, risk and operational processes.”

“Clearing is a business with a huge network effect,” says Mr Karl. “There is an efficiency to be had from clearing many interest rate swaps in one CCP and that mainly comes from the fact that, for margin calculations and capital requirements, you can net together all the swaps in different currencies.”

He adds: “The moment you start breaking out euro swaps, margin requirements would go up massively.”

Liquidity fragmentation

That is because margin is a measure of risk. If the market were to fragment, existing pools of liquidity would become split between several CCPs across the UK and EU, driving up clearing costs and exacerbating pricing volatility. Isda estimates that a full location policy would raise the average margin requirements for dealers by as much as 24%, in what is already a low-profit business. In financial terms, Deutsche Bank calculates that €25bn could be needed in additional collateral to meet margin requirements.

Furthermore, less than a third of all euro swaps cleared at LCH actually involve EU firms, as US banks and asset managers take a large share of activity.

And when it comes to EU clients, the Centre for European Policy Studies (CEPS) estimates that around 40% do not have an account with an EU CCP and would be required to open one under the new rules. CEPS research also shows that while the EC claims it is virtually costless to set up a new account, in reality, costs would begin to ratchet up for users who would need to pay fees to two clearing houses, in addition to having greater regulatory capital requirements. Some buy-side firms, including insurers and pension funds, might also have to launch segregated accounts for each individual client, for all of the funds they need to clear.

These additional costs for European firms “will ultimately be passed to end users, including investors and pension savers,” says Mr Karl.

For European banks, the new clearing rules could impact on their ability to compete, as they would have to restrict business with some non-EU clients. When acting as market makers, banks have no influence over clearing locations for a significant number of their trades because they must clear at the CCP requested by their client. Similarly, banks rely on their ability to re-hedge themselves in a global market to quote competitive prices.

These creases will need to be ironed out over the next year as the legislation works its way through the European parliament and beyond. But time is short — the accountancy firm Deloitte has warned that the new measures will “have to take effect as soon as possible” to give banks time for implementation before equivalence expires.

In February 2022, the EC extended equivalence until June 30, 2025.

Compelling change

With each successive extension, EU officials have pledged that it would be the final deadline — and this time is no exception. Market watchers remain sceptical, especially as there will be a change in political leadership in 2024; but still, many are wary of attempts to accelerate the shift.

“The EC has tried to encourage voluntary change without success, and understands that the cliff-edge risks of a required shift is just too dangerous,” says Mr Carolan, who sees active accounts as a mechanism to force a tipping point in the move to EU clearing houses. “How willing they are to inflict pain on the business and commercial choice of EU market participants in the process remains to be seen.”

Ironically, the biggest winner of this post-Brexit spat is likely to be the second-largest clearer of euro swaps: New York. In January 2021, the EU granted full equivalence to US CCPs, with the Commodity Futures Trading Commission, the main US derivatives regulator, having also successfully fended off extraterritorial oversight from Esma.

Evidence of the seepage of business to the US can be seen in the decision of ICE to move its euro credit default swaps business from London to Chicago in October 2023. At least some of that business will “inevitably migrate to EU alternatives, including LCH’s Paris-based CCP”, but it is unclear to what extent, says Mr Carolan.

However, again, the question of clearing is a global, not a local, one. Other countries do not share in the EU’s concern. For one, “the US appears to be comfortable that most dollar clearing is done in London,” says Nicolas Véron, a senior fellow at both Bruegel and the Peterson Institute for International Economics, think-tanks based in Brussels and Washington DC, respectively.

London already had a strong dollar-clearing business when the euro arrived in 1999 — which is how UK CCPs managed to hoover up euro-denominated IRDs to begin with — and it continues to do so. As of June 2021, 97% of notionally traded US dollar IRDs were cleared in London. Given those market forces, it will be tricky for the EU to dislodge UK dominance.

In its 2022 Triennial Survey, published in December, the BIS found that London’s position had only “marginally eroded” in the past three years, with some activity peeling off to the euro area, such as Eurex Exchange, a Frankfurt-based CCP.

“Eurex has been trying to gain market share quite aggressively in the past few years, but at the end of the day, the market shares haven’t changed that much,” says Mr Véron.

This is because the network effect is strongest with securities that are traded globally, such as OTC derivatives, compared with securities that are concentrated on an exchange.

Brave new world

In the aftermath of the 2008 financial crisis, it was judged by the leaders of the G20 that “increasingly complex and opaque financial products, and consequent excessive leverage” had combined to cause a systemic risk within the global financial system. In response, they convened at the Pittsburgh summit in September 2009 and resolved that OTC derivatives must be cleared through CCPs to improve market transparency and mitigate risk.

There’s an extraordinary concentration of risk in CCPs, which have become critically systemic in a way they weren’t before

Nicolas Véron

As a result, “a whole new world” was created for the clearance of derivatives, according to Mr Véron. “There’s now an extraordinary concentration of risk in CCPs, which have become massively important and critically systemic in a way they weren’t before.

“Maybe that’s good, because risk is no longer with individual banks. But maybe it’s bad, because if something really bad happens to one of those CCPs, who knows what the outcome will be. There’s no precedent of CCP failures.”

While the profile of the risk has changed, it would be wrong to suggest risk has proliferated, argues Mr Karl. On the contrary, the dominance of a single CCP allows regulators to “see the whole picture”, as opposed to if there were a more fragmented market, he says.

Neither is there any real concern of future regulatory divergence. In general, regulators adhere to the standards established by the Financial Stability Board, an impartial international body, with the effect that the EMIR mirrors the US Commodities Exchange Act, for example.

The main sticking point is co-operation in an emergency situation. Supervisory authorities in the UK wield disproportionate power in the global financial system. Last year, the Bank of England even went so far as to propose clarifying its primary aim to maintain financial stability to include a consideration of how UK CCPs might alter other jurisdictions’ financial stability.

Perhaps unsurprisingly, Deloitte observed in a report that “these efforts seem to have done little to persuade the EU that it does not need to act”.


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