Quick Take: With the EU closer to changing the landscape for euro OTC derivatives clearing, post-BREXIT planning for preparatory steps may be necessary.
On May 16, 2018, the Economic and Monetary Committee of the European Parliament backed a proposal (the Proposal) of the European Commission (the Commission), as the executive of the EU, which included amendments aimed at centralizing the oversight over central clearing counterparties (CCPs).
The Proposal is the latest and most serious legislative commitment that, come what may in terms of BREXIT, the business of clearing financial transactions in EUR—the currency of the 19 Eurozone Member States—is to move back into the EU’s Single Market. The Proposal also aims to support making the Single Rulebook more single and also to deliver another building block of the EU’s Capital Markets Union initiative. This Client Alert assesses the scope of the Proposal and what these changes might mean for CCPs as well as clearing members and the clients and counterparties with which they engage.
What does the Proposal do?
The increased oversight of EU and third country CCPs would be achieved by:
- Expanding the role of the European Securities and Markets Authority (ESMA) including supervisory tools and on-site inspections;1
- Changing the recognition procedure for third country CCPs based on their activity and systemic importance in relation to one or more Member States of the EU and allocating them in relevant “Tiers”; and
- Introducing requirements for non-EU CCPs that are categorized as ‘systemic’ to relocate and establish themselves in the EU in order to access the EU’s Single Market.2
The relocation idea has been the subject of a heated debate in recent months due to the potential to relocate the euro over-the counter (OTC) derivatives clearing, 75 percent of which currently takes place in London,3 back to the EU after BREXIT, given that the UK will upon its exit become a “third country” hosting “third country CCPs”. These changes will also impact the circa 17 CCPs established in the EU, all of which are authorized per EMIR to offer services in the EU, but may not in fact do so across all asset classes.
The Proposal will also impact the 28 third country CCPs that have already been recognized by ESMA, and probably impact another 10+ seeking clearance under EMIR equivalence provisions, as a condition to offering their services in the EU.4 The current supervisory arrangements of those third country CCPs have been found to be slow if not deficient, often with certain shortcomings of accessing or sharing information and conducting on-site inspections. As elaborated below, the Proposal’s mandatory relocation kicks-in where the oversight of such third country CCPs were deemed insufficient to meet systemic risk mitigation and / or other supervisory concerns.
Quick Recap: Current regulatory framework for CCPs in the EU
The current regulatory framework for CCPs is set out in the European Market Infrastructure Regulation (EMIR),5 which besides changing how derivatives are documented, executed, reported and supervised, also introduced the obligation to clear OTC derivatives through CCPs and also imposed authorization and prudential requirements on CCPs. Under EMIR, all EU CCPs were required to apply for an authorization with the national competent authorities in September 2013, whereas third country CCPs had to be granted recognition to be able to conduct business in the EU.
EU CCPs are supervised by “colleges” of national supervisors, ESMA and relevant central banks, regardless of whether the euro is the currency of jurisdiction, along with other relevant authorities. At present, the concern is that without a greater centralized coordination by ESMA and the ECB, CCPs are relevant for the entire EU financial system, but supervisory standards are not fully harmonized and there are divergent practices and misalignments between standards of equivalence, recognition and on-going supervision of third country CCPs.
What do the Proposal’s changes to CCP regulation and supervision mean in detail?
The Commission’s Proposal includes amendments to two existing EU directly applicable regulations: EMIR and the regulation establishing ESMA.6 The amendments to EMIR focus on strengthening the framework for authorization of EU-based and third country CCPs (these changes are known as EMIR 2.2), whereas the changes to the competencies granted to ESMA include extending ESMA’s decision-making and oversight powers to ensure consistency of EU-wide supervision of CCPs.
- Greater centralization of pan-European supervisory decision-making
The amendments to ESMA’s competencies include setting up a new committee within ESMA to centralize the supervisory decision-making relating to CCPs. The national authorities will retain their supervisory powers over CCPs, but in the interest of ensuring consistency of application of supervisory discretion across the EU, will need to either consult or obtain prior consent for their decision from specially formed committee within ESMA—the ESMA Board of Supervisors in the CCP Executive Session (the CCP Executive Session).
The ECB and the relevant central banks will be permanent members of the CCP Executive Session, as well as supervisory colleges, and will have binding powers for certain questions. The changes introduced by the Proposal will thus have market-wide as well as individual CCP relevant changes, including possibly members of affected CCPs and their clients.
This dedicated CCP committee will have power in relation to decisions pertaining to prudential requirements for CCPs (Title IV of EMIR) and rules on interoperability (Title V of EMIR). Other decisions related to CCP supervision will be subject to the non-objection of the committee. The Board of Supervisors in its CCP Executive Sessions will include members of the Board of Supervisors of ESMA and a representative of the Commission, the European Central Bank (ECB), the national competent authorities and the central bank of issue.7
This change reflects a move towards more supervisory convergence and a more consistent EU-wide approach, similar to the one introduced in banking supervision in 2014 through the Single Supervisory Mechanism and the European Central Bank as its core centralized decision-maker. A significant application of ESMA’s new extended powers relates to the authorization process of EU and third country CCPs.
- Greater involvement of the central banks in CCP supervision
The new European supervisory mechanism for CCPs, envisaged in the Commission’s Proposal includes involvement of not only national competent authorities and ESMA, but also greater engagement with the “central banks of issue”. In the Eurozone the central bank of issue is the ECB. The Proposal introduces a requirement for the national competent authorities to seek consent from the central banks of issue with regards to certain decisions relating to the supervision of CCPs.8 If the central bank of issue objects to the decision, such a decision cannot be adopted. Any amendments proposed by the central bank must also be considered.
The type of decisions include the authorization of a CCP, extension of activities and services of a CCP, withdrawal of authorization, margin requirements, liquidity risk controls, collateral requirements, settlement and approval of interoperability arrangements. On July 4, 2018, the European Parliament voted in favor of amending Article 22 of the Statute of the European System of Central Banks and of the European Central Bank, thereby granting the expanded oversight powers.
- Changes to the recognition process of third country CCPs
The Proposal amends the procedure of recognition of third country CCPs, which enabled clearing houses established outside of the EU to provide clearing services within the Union upon being recognized by ESMA under the EMIR equivalence provisions. The new legislation will, as part of the recognition process, classify third country CCPs according to the risk they present to the financial stability of the EU or one of its Member States.9
The classification criteria will include “the nature, size and complexity of the CCP’s business, including the value of the transactions cleared in each EU currency, the impact of failure of the CCP on the EU markets, as well as the CCP’s structure and interdependencies with other market participants.”10 The European Commission has been tasked with issuing a Delegated Act, which will further set out the risk assessment criteria that CCPs can be measured against. A classification must be reviewed at least every two years.11
The Proposal aims to improve supervisory oversight by distinguishing third country CCPs further than the current regime and splitting them into a two-tier system of:
- Non-systemically important CCPs (so-called Tier 1 CCPs): which will continue to be able to operate under the existing EMIR equivalence framework; and
- Systemically important CCPs (so-called Tier 2 CCPs): which will be subject to stricter requirements. A limited number of systemically important CCPs may be of such systemic importance, that the requirements are deemed insufficient to mitigate the potential risks (so called ‘substantially systemically important’ (Tier 2 SSI CCPs) in the absence of having been defined perhaps by the easier term “Tier 3 CCPs”. In such instances, a decision may be taken by the European Commission, on recommendation from ESMA (and possibly national supervisors) allowing a CCP to provide services in the EU if it is authorized under EMIR and establishes itself in the EU i.e., it relocates.
The Proposal’s approach, specifically in its focus on systemic criteria, creates clear options for CCPs and the market participants that interact with CCPs. Whilst a lot of the Proposal may be relevant in the context of BREXIT, its drafting is “jurisdiction agnostic” and fits in with other EU and/or Banking Union regulatory and supervisory workstreams. Those other workstreams have a proven application of referencing an entity’s’ “systemic profile” as a distinguishing feature and thus whether these should be subject to specific risk mitigation and/or additional compliance measures, or in addition, be subject to direct oversight, regardless of where the business is conducted.
Tier 2 CCPs, will need to demonstrate compliance with EMIR's prudential requirements (Titles IV and V of EMIR) and may be subject to onsite inspections by ESMA.12 A Tier 2 CCP will also need to comply with any requirements posed by the relevant EU central banks of issue, such as availability of certain type of collateral, levels of haircut applied to collateral, investment policy or collateral segregation, availability of liquidity arrangements between the central banks involved and the impact that the failure of the CCP would have on the financial stability of the EU.
The aim of the proposed provision is to enhance the access to information from a CCP with a view to increasing the insight into the risk management practices, enabling the monitoring and the changing supervisory framework in third countries and ultimately ensuring a level playing field between the EU and third country CCPs. ESMA will consider the extent to which the prudential requirements are satisfied through the CCP’s compliance with the comparable rules applicable in third countries. As part of this system, a third country CCP classified as Tier 2 may request that ESMA assesses the comparability of EMIR requirements and the relevant third country standards. If the rules are found to be comparable, ESMA may waive the application of all or some of EMIR requirements.
CCPs which have already been recognized under EMIR will continue to operate as Tier 1 CCPs until ESMA decides that a relevant third country CCP is a Tier 2 CCP. Both Tier 1 and Tier 2 third country CCPs will also be required to pay annual fees to ESMA for its ongoing supervision tasks. The Commission will develop a Delegated Act which will set out in detail the types and amount of fees to be paid by both EU and Tier 1 and Tier 2 third country CCPs.
The highly debated part of the Proposal is the process allowing ESMA, in consultation with the relevant central banks, to recommend to the Commission to issue an implementing act refusing to recognize a third country Tier 2 CCP, if the CCP is of such systemic importance that compliance with EMIR or comparable requirements is deemed insufficient to ensure financial stability of the EU or a particular Member State. In such scenario, the CCP will need to establish itself in the EU in order to be able to provide services within the Union. The economic consequences of this “last resort” provision, if triggered, could be very disruptive.
So how much will this cost and who will pay it?
Increased supervisory scrutiny comes at cost. This includes costs borne by supervisors themselves and paid by CCPs. The Proposal’s financial and staffing projection through to year-end 2020 for the CCP Executive Session calls for ESMA to create and fill circa 50 positions and for it to receive an operating budget of circa €22 million, which is to cover operating costs including additional office space as well as event-driven costs related to supervisory missions, i.e. inspections to CCPs which are anticipated to run to €240,000 a year. The third country CCP costs on recognition and ongoing supervision will reflect whether they are a Tier 1 CCP or a Tier 2 CCP and are intended to be proportionate to the actual costs ESMA incurs.
All of these additional expenses are to be “largely met” by supervisory fees paid by CCPs. Whilst the Proposal explains some of the calculations for ESMA’s costs, it is silent as to exact additional costs of the ECB and national supervisors and what this might mean for CCPs supervisory fee notices.
Implications of the proposal on the post-BREXIT clearing landscape
Concentration has long been central to CCPs and their operations as well as their risk profile. Example of such concentration is visible in the market for clearing of euro OTC derivatives where London’s LCH Clearnet holds a dominant position (97 percent of euro-denominated interest rate derivatives are cleared there). The EU’s concern, which it is aiming to address with the Proposal, is that after BREXIT those CCPs, which are of systemic importance to the EU, could be located outside the Union’s borders.
The consequence of EMIR 2.2 and the possible refusal of recognition of a systemic third country CCP could be a move of a large portion of euro OTC derivative clearing to the EU - an option which sparked a heated discussion between the two sides of the English Channel in June 2017, when the Commission published the Proposal. The EU has had a longstanding ambition to move euro derivative clearing to the EU, or even more restrictively, to the Eurozone. In March 2015, the ECB lost a case against the UK in the European Court of Justice where the EU court supported UK’s request for annulment of an ECB policy attempting to restrict euro clearing to the Eurozone. The decision will no longer be binding if the “last resort” option, requiring a third country CCP to establish itself in the EU, is exercised by the European Commission, following a recommendation from ESMA.
With EMIR 2.2, the EU lawmakers attempt to prevent regulatory and supervisory arbitrage by foreign regulators in favor of third country based CCPs and at the expense of EU-domiciled CCPs. One of the arguments in favor of the relocation of clearing would be the possibility to create a more uniform regulatory landscape, encompassing supervision, recovery and resolution. The Commission’s proposal on a recovery and resolution framework for CCPs, approved by the European Parliament in January 2018, complements the CCP regulatory architecture. A banking crisis involving systemically important ECB-supervised banks would have a significant impact on the relevant CCPs. The converse situation, involving a failing CCP and a knock-on effect on its clearing member banks is also possible. In these low probability but high impact cases, a tight cooperation among EU supervisors would be necessary and such cooperation, the argument goes, would be impeded if a CCP was domiciled outside of the EU.
On the other end of the Channel, a number of UK market players voiced their concerns about the proposed amendments, including in their responses to the Commission’s consultation on the proposed rules in 2017. The Proposal has been criticized for acting as a "location policy", restricting the freedom of choice of a clearing venue and artificially forcing flows away from certain CCPs. The effect of these changes, the UK market participants argue, could be to replace a market-driven concentration in the clearing market with a geographical one. The relocation of euro clearing could reduce liquidity by fragmenting the market, increasing the difficulty of finding the other side to a position, and as a result raising costs which would be passed on to EU citizens. Mark Carney, in his speech on 20 June 2017,13 pointed to the increased costs stemming from the application of a location policy on clearing which took place in Japan. Additional expenses could also be borne at the point of default. Clearing members are required to contribute to a default fund by virtue of EMIR. The members of a small CCP could bear a higher financial burden stemming from the default of one of the small CCP’s clearing members than in the case of a larger global one. In this way, the inherent risk management system built in the CCP design, relying on risk being distributed amongst a large group of participants, could be compromised. The International Swaps and Derivatives Association (ISDA), in its April 2018 paper14 advocated against implementing EMIR 2.2 and instead focusing on establishing an international regulatory cooperation framework.
Implications for clearing members
The EMIR 2.2 proposal adds another level of complexity and uncertainty to BREXIT-related contingency planning for financial institutions in relation to their clearinghouse memberships and the continuity of their derivative contracts. In addition to considerations relating to whether the UK CCPs will be granted EMIR equivalence post-BREXIT, the Proposal also imposes another layer of regulatory risk through the more remote, but equally severe option to deem third country CCPs as systemic. Both of these events may require a move of an unprecedented volume of derivative risk between CCPs across different jurisdictions, including tremendous operational costs related to the legal and technical execution of the portfolio relocation. The potential need to switch between CCPs is an operation which will require advance planning. As pointed out by ISDA: “Connecting to a CCP is a time-consuming and labor-intensive process, requiring legal, operational, financial and risk management expertise.”15
Moreover, the initial margins requested by EU CCPs and thus specific types of collateral assets are predicted to increase due to reduced netting opportunities resulting from the EU CCP’s, at least initially, smaller and less diversified clearing portfolio. Funding costs would thus increase as clearing members need to source the extra collateral. The clearing members may also be required to hold additional capital. The exact increase in capital requirements will depend on the risk assessment, determining the revised risk profiles of the CCPs. The contributions to the CCP default fund made by the clearing members are also risk-weighted. As these contributions increase, so does the regulatory and economic capital required to be held against them.
Outlook and next steps
The EU legislative changes on CCPs seem to be well underway; however, the exact consequences, in particular whether ESMA will be making use of its “last resort” option in order to bring euro clearing to the EU, will only be known after BREXIT. What is known is the comprehensive EMIR regulatory framework, encompassing prudential, conduct, interoperability rules and on-site inspections, will continue to apply to both EU-based CCPs, and, after EMIR 2.2 enters into force, also to third country systemic CCPs.
Some third-country CCPs may already want to start forward planning to either move to the EU-27 or the Eurozone or demonstrate how they are either a Tier 1 CCP as opposed to a Tier 2 CCP, and, if a Tier 2 CCP, to justify how they are not a Tier 2 SSI CCP that would otherwise be susceptible to regulatory driven relocation. Such measures could involve CCPs working with their counsel, specifically in relation to the relevant opinions that are required, and professional advisers to benchmark their own operations, and ability to split these out, against the relevant criteria but also to assess how their operations and perceived systemic risk profile compares against those EU CCPs and whether they are a Tier 2 SSI CCP that will likely have to relocate its EU relevant business to the EU.
One issue that could derail relocations from happening as rapidly as EU policymakers would like, is that the EU financial centers (currently) lack the same concentration of transatlantic cables linking data and routing centers and thus the orders in respect of financial transactions across the Atlantic. For the moment, that could mean (assuming those cable/satellite/microwave connections remain resilient) that, depending on the tone of BREXIT negotiations, that clearing might stay a little longer in the UK and be overseen by more invasive EU supervision prior to a forced move. This however does not derail the opportunities for those looking to move ahead regardless.
If you would like to receive more analysis on the Proposal or any other issues raised herein, please contact one of our Eurozone Hub key contacts listed on the right.
1. See our dedicated coverage on the ECB’s own new rules on supervisory inspections which may be of interest: https://www.dentons.com/en/insights/articles/2018/august/3/the-draft-ecb-ssm-supervisory-guide-to-on-site-inspections-and-internal-model-investigations
2. Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending Regulation (EU) No 1095/2010 establishing a European Supervisory Authority (European Securities and Markets Authority) and amending Regulation (EU) No 648/2012 as regards the procedures and authorities involved for the authorization of CCPs and requirements for the recognition of third country CCPs https://eur-lex.europa.eu/resource.html?uri=cellar:80b1cafa-50fe-11e7-a5ca-01aa75ed71a1.0001.02/DOC_1&format=PDF
3. According to the Bank of International Settlements.
4. ESMA periodically updates the list of CCPs in accordance with Art. 88(1) EMIR, so the following provides an indicative list: https://www.esma.europa.eu/sites/default/files/library/ccps_authorised_under_emir.pdf
5. Regulation (EU) No 648/2012 of the European Parliament and of the Council of July 4, 2012 on OTC derivatives, central counterparties and trade repositories
6. Regulation (EU) No 1095/2010 of the European Parliament and of the Council of November 24, 2010 establishing a European Supervisory Authority (European Securities and Markets Authority)https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32010R1095&from=EN
7. Article 1(7) of the Proposal, page 40.
9. Article 2(9) of the Proposal, page 48.
10. Article 2(9)(b) of the Proposal, pages 48-49.
11. Article 2(9)(c) of the Proposal, page 49.
12. Article 2(9)(b) of the Proposal, page 48.
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