#Brexit: Clearing houses likely to clear off

The UK accounts for three-quarters of derivative transactions denominated in euros or other EU currencies. It is estimated that this business is linked to 83,000 jobs in the City of London, writes Catherine Feore.

After much speculation, the European Commission’s proposal on clearing counterparties (CCPs) indicates that some CCPs that are of ‘substantial systemic significance’ will only be recognised by the EU if they are established in one of the EU’s member states.

The Commission’s latest proposal for amendments to EMIR – the European Market and Infrastructure Regulation – is in large part due to what the proposal describes as a “specific-systemic risks linked to the United Kingdom’s withdrawal of the United Kingdom from the EU”.

European Commission Vice-President Valdis Dombrovskis, with responsibility for financial stability, financial services and the Capital Markets Union said:

"The continued safety and stability of our financial system remains a key priority. As we face the departure of the largest EU financial centre, we need to make certain adjustments to our rules to ensure that our efforts remain on track."

Large CCPs have already been crying foul accusing the European Commission of fragmenting the successful clearing business. One CCP estimated that the costs to banks could amount to as much as $77 billion; more realistic estimates say a figure of less than $10 billion would be a more realistic number. A senior commission official said the draconian $77 billion figure was not just based on the car crashing, but everyone inside the car dying.

George Osbourne while Chancellor of the Exchequer made a successful legal challenge contending that the ECB lacks the necessary competence to impose a location requirement in respect of CCPs.

The European court ruled that if the power to decide on location was necessary the EU would have to amend EMIR adding an explicit reference to the location of securities clearing systems.

Speaking to Bloomberg TV’s Francine Lacqua, Benoît Cœuré, Member of the Executive Board of the European Central Bank (ECB) said:

“So far, we’ve been able to ensure the safety and soundness of euro-denominated clearing through very robust arrangements that we have with the Bank of England and with the CCPs located in London, and that works very well.

"The basis for the arrangements will fall in 2019, when the UK leaves, and so we need an alternative… [The ECB] certainly need to play a strong role here. But when it comes to requirements which will be hard-wired into European law – so say, for instance, location: do we need location? – That’s for the Commission to have a say. That’s not for us to decide.”

Light-touch regulation

Prime Minister May and Brexiteers still hold on to the idea that the UK can leave the EU and still make a success of it. One of the suggestions is that the UK can become a dynamic fleet-of-foot deregulated market free of stodgy European regulations.

There is no doubt that this is a concern for the EU. What is known as ‘regulatory arbitrage’ could result in the UK loosening its rules to attract more business; perhaps through narrower margins or lower capital requirements. However, a European Union that is still recovering from the impact of the financial crisis is unwilling to play fast and loose with its financial stability.

EMIR

The EMIR implements the G20 commitment in 2009 to increase stability in the massive derivatives market following the financial crisis. Today that market amounts to USD 544 trillion. Carefully regulated central counterparties reduce the risk of instability, but risk in the system remains.

To address the risks posed by third-country CCPs, the Commission’s proposal divides the market into two tiers. The first tier deals with non-systemically important banks; for these CCPs it is business as usual.

The second tier CCPs are further divided into ‘systemically important’ and ‘substantially systemically important’ CCPs. Tier two CCPs will have to comply with current rules, but could also be subject to additional requirements imposed by EU-central banks. The third-country CCPs will have to submit to on-site inspections by the European Securities and Markets Authority (ESMA) based in Paris.

If a CCP is judged to be 'substantially systemically important' the Commission can refuse to recognise it unless it relocates to an EU member state.

A reinforced ESMA will play the key role in determining whether a CCP is “systemically important or likely to become systemically important”. This will be based on how much it clears, how many EU-entities are linked to it and its potential impact on financial stability should it fail.

The new proposal also gives the EU central banks– as ultimate providers of liquidity – a ‘binding decision power’ in surveillance.

Some London CCPs will vote with their feet, with many already looking into the costs of relocation and any IT or regulatory changes that they need to make.

Though widely anticipated, yesterday’s announcement will send shock waves through the clearing world and the wider UK financial sector. The British Conservative Party has long-standing links to the City of London; it remains to be seen if yet another repercussion of Brexit will knock a ‘hard Brexit’ off course.

Share this article: