Apostolos Thomadakis and Karel Lannoo / Dec 2021
Derivatives markets have grown significantly over the last two decades, while central clearing has advanced enormously since the global financial crisis and the G20 commitments – in particular the requirement that all standardised over-the-counter (OTC) derivatives should be centrally cleared.
The largest derivatives central counterparty clearing houses (CCPs) have been developed in the City of London, a leading global central clearing hub of OTC derivatives of all asset classes and currencies. Currently, three UK-based CCPs dominate the (European) market for swaps and futures clearing. About 94% of all euro-denominated interest rate swaps (IRS) that are traded globally are cleared in London. On the other hand, EU-based CCPs account for only 6%.
Figure: CCPs’ share of cleared IRS by notional traded
(% of globally cleared IRS, H1 2021)
Concern about the risk in CCPs and foreign currency exposure has been an issue among EU policymakers and supervisors for the last two decades. However, and since the departure of the UK from the EU, these concerns have been intensified. European policymakers have encouraged EU clearing members and market participants to reduce their exposure to systemically important UK CCPs. At the same time they are persuaded to further develop EU’s derivatives clearing capabilities.
Ensuring that financial stability risks are adequately managed and that EU financial institutions that participate in UK CCPs are sufficiently protected, is the EC’s primary task. As such, the European Market Infrastructure Regulation (EMIR) 2.2 was introduced as a means to enhance the EU framework for the supervision of third-country CCPs. The direct application of EMIR standards to systemically important CCPs, and the direct involvement of the European Securities and Markets Authority (ESMA) (and EU central banks) in monitoring and supervising recognised third-country CCPs, resolves some of the policy issues raised by the heavy reliance of the EU financial system on services provided in London.
Potential benefits of increased use of EU CCPs could include cross-product netting with listed derivatives, which could promote trading within the EU. This could also stimulate the creation of legal, economic and operational expertise that could spur the development of EU financial centres.
However, UK-based CCPs serve a global market, not only a European one. Thus, a requirement by EU authorities for EU-based firms to move away from UK CCPs will restrict those firms’ access to liquidity, increase their clearing costs and negatively affect the competitive position of EU companies internationally. It will create two distinct marketplaces, one for EU firms and another for non-EU firms, which will disadvantage EU banks compared to their international counterparts. It will become more expensive for EU-based operators to clear their positions at UK CCPs, and will impact their client-clearing and market-making activities with non-EU clients and counterparties. At the same time, non-EU banks will preserve their ability to offer their services to non-EU clients and counterparties.
Location policies have been considered in the past in other jurisdictions than the EU, but these were either abandoned as a policy option or drastically scaled down. In Australia and Canada, for example, regulators decided instead to strengthen cross-border regulatory cooperation with third countries, given the liquidity and resilience benefits provided by global CCPs. In Japan, on the other hand, the requirement for Japanese entities to clear their home currency-denominated IRD through a local CCP has effectively resulted in these entities being restricted to the local liquidity pool. It has thus created fragmentation between the activities of Japanese banks, which clear through the local CCP, and global banks, which typically clear through a global CCP.
In the short term, the best way forward is to implement appropriate supervisory and regulatory cooperation between both jurisdictions. EMIR 2.2 ensures orderly cooperation between the EU and the UK, and allows for hands-on supervision by ESMA of UK-based CCPs deemed systemically important to the EU. Moreover, central banks – the Bank of England (BoE), the European Central Bank (ECB) and other Central Banks of Issue (CBIs) – are fully involved in the supervisory structure and form part of the supervisory colleges. The new supervisory structure needs to be given time to function properly before any more radical changes are introduced, given their significant potential negative consequences on EU firms.
In the long term, any EU policy to further develop central clearing in the EU should be part of a clear strategy in the context of the Capital Markets Union (CMU). The current concentration of derivatives clearing in the UK has developed over a long period as part of the single market, and thus – even if pursued as an EU policy objective – restricting access by EU firms cannot be achieved easily, or without collateral damage for EU banks and end users. Moreover, central clearing is integrally connected with other building blocks of a large financial centre, such as the presence of intermediaries and end users, widespread subject matter expertise, a suitably adapted legal framework and strong underlying infrastructures.
EU market participants should be able to retain the flexibility to continue to clear their transactions through the CCP of their choice or the choice of their clients and counterparties, and benefit from access to global pools of liquidity and product ranges that meet their needs. This is even more the case when their regulatory and supervisory regimes are equivalent to the EU one. Enabling participants in the marketplace to determine the optimal market structure based on their trading needs and objectives will allow for a more organic, market-led and customer-driven development of EU derivatives market infrastructure. This will keep the EU financial markets open, global and attractive, while strengthening the international role of the euro.
This article is based upon the report Setting EU CCP Policy – much more than meets the eye by Apostolos Thomadakis and Karel Lannoo.