A time for tiers

Central counterparty clearing houses (CCPs) have come to play a critical role in the international financial landscape. However, in the wake of Brexit, the EU's perceived over-reliance on UK CCPs has triggered regulatory attempts to re-shore capacity. Despite a recent announcement that EU temporary equivalence will be extended, the European Commission remains steadfast in these re-shoring efforts. Industry stakeholders should brace themselves for the increased costs that will result from the consequent relocation of derivative positions.

Context

Over the past decade, CCPs have become increasingly global and interconnected - predominantly as a deliberate outcome of financial crisis reforms. In fact, in 2009, the G20 mandated that all standardised OTC derivates contracts be cleared through CCPs — something the EU (which, at the time, included the UK) adopted via the 2012 European Market Infrastructure Regulation (EMIR). However, this increasingly central role has also meant that potential disruptions pose a larger risk to the wider financial system — as we are learning through the post-Brexit experience.

Almost one year on from the Brexit deadline, the bulk of EU clearing continues to take place in London — with UK CCPs clearing about 80% of euro-denominated interest rate derivatives and 40% of credit default swaps. The European Commission (EC) has come to view this dependence as a financial stability risk and, as a result, is attempting to draw clearing activity back to the continent.

Tiers and extended equivalence, but not forever

Under EMIR, EU counterparties can only satisfy their clearing obligation for mandated derivative products by clearing them through an authorised EU CCP, or a third country CCP that has been granted equivalence by the European Securities and Markets Authority (ESMA). Clearing products at other, non-qualified CCPs, results in prohibitively high capital requirements. In 2020, an updated framework (EMIR 2.2) was finalised which tiers third country CCPs according to their risk level.

Following the transition period, the UK on-shored EMIR 2.2 and, in November, the Bank's Christina Segal Knowles confirmed that rather than diverging, the UK will continue to implement its own `safe openness' version of EU tiering. For both jurisdictions, tiering continues to sit on top of the equivalence process.

The UK HM Treasury (HMT) originally granted non-UK CCPs temporary recognition until the end of 2023, with a clear commitment to extend this, if necessary. Since then, HMT has confirmed formal equivalence of the EU supervisory regime for CCPs - and so, subject to cooperation arrangements being in place with the relevant national authority, EU CCPs will be able to apply for permanent recognition and continue serving UK members once temporary equivalence expires.

EU regulators are not expected to respond in kind. In September 2020, the EC adopted temporary equivalence for UK-based CCPs until 30 June 2022, to avoid any 'cliff edge' drop-off in access to clearing services following Brexit. And, following extensive industry lobbying, this equivalence is now expected to be extended early next year — an expectation further strengthened by the recent findings of ESMA’s assessment of UK CCPs’ systemic importance. However, rather than settling on a permanent solution for UK CCPs, the Commission plans to use the temporary extension to reduce UK exposure and expand the EU's own clearing capacity by enhancing liquidity, increasing the range of offerings and strengthening the supervisory framework.

Early signs indicate the EC's strategy may be starting to take effect - Eurex has seen its market share for euro denominated interest rate swaps increase by 0.5% per month, while LCH's share has decreased by a similar amount. The trading of EU carbon contracts and euro-denominated shares also appears to be gradually shifting from London to the continent.

The EU is also attempting to reduce UK-dependence in other ways. Following “several years” of discussions, in January the EU granted permanent equivalence to the US SEC regime for CCPs. Additionally, open access provisions for exchange-traded derivatives have been scrapped - in order to “foster competition, innovation and development of exchange-traded derivatives in the EU on one side and building further clearing capability in the EU”.

Impact on firms

As a result of HMT's permanent equivalence decision, the road ahead seems relatively clear for UK members using EU CCPs. They face neither a drop-off in access nor punitive capital requirements.

With the EC unlikely to respond in kind, more bumps are expected for EU members using UK CCPs. Despite some evidence of liquidity organically migrating back to the EU, the continuing growth of the global derivatives market suggests that substantial repatriation won't be easy. The movement could result in additional costs for EU members, either in the form of new capital requirements or from trading in less liquid and fragmented markets. Any additional costs, either regulatory or market-driven, will no-doubt be passed on to members' clients. John Berrigan (Head of the EC's Financial Services unit) has emphasised that difficulties will only be exacerbated if equivalence runs out too soon.

Transferring positions (271 KB) from UK CCPs to EU CCPs would mean replacing one set of rights with a new set of rights. This process is a complex one and requires accounting for the following considerations:

• Universal agreement would be required across all affected participants (counterparty members and, in turn, their clients).
• The CCPs involved may not have the same clearing members, and therefore some counterparties may first need to become members of successor CCPs - often at substantial cost (default fund contributions, exposure collateral considerations).
• Successor CCPs may need to obtain EMIR authorisation to clear new types of contracts.
• A sudden influx of positions could create capacity issues (both operational and capital-related) for successor CCPs and could result in a further concentration of risk.

As for the UK CCPs themselves — to the extent that the considerations above are accounted for and liquidity successfully migrates to the EU — in this zero-sum game they stand to lose the members that the EU gains.

In order to be best prepared for the changes to come, CCPs and the members they serve should stay abreast of the latest developments. In particular, these stakeholders should use the EC's extended equivalence timeline to consider the actions required.