14 June 2017

The European Commission yesterday unveiled its much-awaited proposal to amend the European Market Infrastructure Regulation (EMIR) with regard to the supervision of clearing houses that handle euro-denominated transactions but are based outside the EU. A clearing house – or Central Counterparty (CCP) in regulatory jargon – is an entity that sits between buyers and sellers of financial instruments, such as derivatives, and manages the risk that could arise in the event one of the parties defaults on the agreement.

This new proposal is of great interest to the UK in light of Brexit – the City of London is a major centre for the clearing of euro-denominated transactions. This saga has been going on for a few years. In 2015, the UK won a landmark case at the European Court of Justice (ECJ) following a first attempt by the European Central Bank (ECB) to argue that clearing houses handling euro-denominated transactions should relocate into the Eurozone. Open Europe’s paper on the future of the UK’s financial services sector after Brexit, published last October, provides extensive background on this topic – so I won’t rehash all of it here.

It is worth looking at the Commission’s proposal and what it means in the context of the Brexit negotiations that are expected to kick off next week.

No nuclear option

The most significant aspect is that the Commission has shied away from the ‘nuclear option’ – that is, simply to propose that all clearing of euro-denominated transactions be automatically moved to the EU or the Eurozone. In other words, the Commission has opted for a far more cautious approach than the rather belligerent declarations made by several senior politicians across Europe (see, for instance, what then French Finance Minister Michel Sapin told the Financial Times only two months ago).

This suggests the Commission is well aware of the possible consequences of forcing a mass relocation of euro clearing business, including:

  • Increased transaction costs. Clearing is about economies of scale. Traders have to post collateral with the CCP that executes the transaction. Hence, the advantage of having a number of different financial instruments traded through a single clearing house is that it significantly reduces the amount of collateral needed by netting off margin on the various trades. Inevitably, greater fragmentation would lead to increased transaction costs.
  • Increased concentration of risk. If non-EU CCPs were cut out of the business of euro clearing altogether, this would lead to reduced choice for traders. In other words, there could be a very limited number of EU-based CCPs available to clear certain financial instruments – which in turn could increase the concentration of risk.
  • Relocation costs. As for other financial services industries, relocating is not a cost-free exercise. Market infrastructure may not be as up-to-date as it is in the City of London, obtaining the necessary licences can take time, and moving staff in large numbers may end up offsetting any gains of leaving London.

Overall, it would therefore be unfair to see yesterday’s proposal as openly hostile to the UK. The new rules would of course also apply to other non-EU countries whose CCPs have obtained recognition in the EU and are therefore allowed to clear euro-denominated transactions – notably including the US, Hong Kong, Singapore and Switzerland.

The Commission is seeking significant leeway for itself

Nonetheless, the proposal does have some problematic aspects. Under the Commission’s plan, non-EU clearing houses would be divided into two categories. Non-systemically important CCPs (Tier 1) would continue to be subject to the existing equivalence regime – see this blog post I wrote a few months ago for background.

Systemically important CCPs (Tier 2) would be subject to a number of additional requirements in order to be allowed to continue handling euro-denominated transactions. Firstly, they would be expected to comply with the same prudential rules as EU-based CCPs, notably on capital requirements. Secondly, they would need to comply with any additional requirements set by the central banks of EU member states involved in a transaction. Thirdly, and perhaps most controversially, they would have to let the European Securities and Markets Authority (ESMA) – the EU’s financial markets watchdog – carry out on-site inspections where necessary.

It would be up to ESMA to decide whether a non-EU clearing house is systemically important, based on criteria the Commission is due to publish within the next six months. Given the huge volume of transactions processed in the City every day, London-based clearing activities would be virtually certain to fall within the ‘systemically important’ category.

Crucially, ESMA and the Commission could also take a further step and rule that a non-EU CCP is of such systemic importance that even the additional requirements outlined above are not sufficient to mitigate risk – and therefore request that it relocate to the EU if it wants to continue clearing euro-denominated transactions.

Perhaps unsurprisingly, with this proposal the Commission is therefore looking to grant itself significant leeway. However, this would risk translating into greater regulatory uncertainty for those non-EU clearing houses that are deemed systemically important. In practice, at any point in time they could be asked to choose between relocating to the EU and losing the right to clear euro-denominated transactions. Furthermore, the proposal entails a degree of extra-territoriality – as ESMA would be asking for the right to conduct on-site inspections of CCPs based outside the bloc.

In fairness, though, the latter would not be unique to the EU. The Commodity Futures Trading Commission (CFTC), the US opposite number of ESMA, demands similar supervisory powers over foreign clearing houses that intend to handle dollar-denominated transactions. However, the US regulator does not enforce any kind of location policy. As the CFTC’s Sharon Bowen stressed in a recent speech,

We do not insist that only US entities handle US-denominated products […] As regulators, we do not believe that it is in our purview to determine where the market takes its business – this is a global market so the solutions will be all over the globe.

A good omen for the Brexit negotiations?

How should this proposal be interpreted in light of the Brexit negotiations that are about to start? The plan is definitely more nuanced than a blanket ban on euro-denominated clearing taking place outside the EU. This in itself could be seen as a good omen – the Commission has shied away from more drastic, politically motivated measures because it has acknowledged that they could have a negative impact on the European economy as a whole. However, as I explained above, the proposal still carries a big stick and therefore raises questions as to whether the EU is moving towards a more protectionist stance vis-à-vis not just the UK, but also other major financial hubs across the world. Time will tell whether the Commission’s plan will be endorsed by EU member states, and what changes it will undergo in the process – but the first impression is close UK-EU regulatory and supervisory cooperation could still go a long way in avoiding relocation of euro clearing business after Brexit.