EU Seeks Power Over London Derivative Clearing After Brexit

  • Lawmakers could require clearing to take place inside the bloc
  • Commission seeks input on the proposal before new bill in June

The European Union seeks to retake control of the lucrative, London-dominated business of clearing euro-denominated derivatives, turning up the heat on a divisive issue with Brexit talks looming.

The European Commission proposed measures to protect against financial-stability risks posed by clearinghouses outside the bloc that play a “systemic role” in its markets. This could mean “enhanced” EU supervision of major U.K. firms, including London Stock Exchange Group Plc, that clear as much as 75 percent of euro-denominated interest-rate derivatives. The EU could also require clearing to take place inside the bloc.

“The foreseen withdrawal of the United Kingdom from the EU will have a significant impact on the regulation and supervision of clearing in Europe,” the commission said on Thursday. Major clearinghouses that have a direct impact on EU financial stability and monetary policy must be “subject to safeguards provided by the EU legal framework,” the bloc’s executive arm said.

Euro clearing has emerged as a bone of contention between the U.K. and the other 27 EU countries ahead of Brexit talks, with both Germany and France seeking to chip away at London’s dominance in the business. 

The commission’s proposal is likely to add to the acrimony that flared up this week, with Prime Minister Theresa May accusing EU officials of interfering with the U.K. election. May lashed out after the publication of unflattering and detailed accounts in the German media of an April 26 dinner with European Commission President Jean-Claude Juncker.

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Chancellor of the Exchequer Philip Hammond said on Thursday that while the U.K. would consider any EU proposal on its merits, “we should be careful of any proposals which might disrupt growth, raise the cost of investment in Europe and the U.K. or weaken financial stability.”

London’s role as the “world’s number one financial center” benefits all of Europe, Hammond said. “We trust everyone in the negotiations will see the value in not undermining that.”

The commission’s proposal jibes with a call from the European Parliament to ensure that clearing and supervision of euro-denominated derivatives trades is controlled by EU institutions after Brexit.

“The fact that euro clearing is currently taking place in London, and thereby outside of the euro zone, is an anomaly that cannot be maintained after Brexit,” EU lawmaker Markus Ferber said on Thursday. “EU supervisory authorities need direct scrutiny and intervention powers and this is most effectively accomplished on European soil. The European Parliament will make sure that this principle will be firmly anchored in European law.”

‘Strong Link’

The U.K. successfully challenged a previous attempt by the European Central Bank to claw euro clearing away from London. EU judges ruled in March 2015 that the ECB can’t dictate where euro-denominated trades are cleared.

Executive Board member Yves Mersch said on Thursday that the ECB welcomes the commission’s recognition of the “strong link” between clearinghouses and the central bank of issuance.

The rules forcing certain trades to go through central counterparties were a response by Group of 20 nations to the financial crisis, when governments around the world were spooked by the damage inflicted by derivatives. Clearinghouses stand between the two sides of a derivative wager and hold collateral, known as margin, from both in case a member defaults.

The industry wasted no time in firing back.

“A forced relocation of euro-clearing would lead to disruption, uncertainty and fragmentation of the market,” said Miles Celic, chief executive officer of lobby group TheCityUK. “A potentially less liquid and less competitive EU market would result in higher costs for European savers and investors,” he said. “This is in no one’s interest and is entirely avoidable.”

Reserve Currency

Barnabas Reynolds, a London-based partner at Shearman & Sterling LLP, said requiring firms to set up shop in the EU isn’t a credible option, because it would reduce the value of the euro as a reserve currency. “If you start mandating limits on the use of the euro, it just basically means the euro isn’t a currency in the same way as sterling, dollars or yen,” he said.

The commission seeks feedback on the proposal before it comes out with further draft legislation on clearing in June.

On Thursday, the commission also proposed changes to the derivatives rules known as the European Market Infrastructure Regulation, which was introduced in 2012. These include an additional three-year exemption for pension funds from the requirement to use central clearinghouses for their trades, with the possibility of a two-year extension. An earlier draft of the bill allowed prolonging the exemption twice by three years.

Clearing presents a challenge to pensions funds, which traditionally hold little cash or other highly liquid assets that can be used as collateral, the commission said. At the end of last year, the commission already extended an exemption for pension funds to August 2018.

‘Viable Solution’

The exemption allows the “various counterparties at play, including CCPs and the clearing members that provide clearing services, to develop a viable solution,” the commission said. “This proposal ensures that both pension funds and policy holders avoid facing estimated additional costs of up to 1.6 billion euros.”

The overhaul of EMIR also intends to ease reporting standards. Derivative contracts concluded on exchanges would only have to be reported by the clearinghouse on behalf of traders. Non-financial counterparties such as corporates will also get a break from some reporting requirements.

“Our proposal aims to reduce costs and reporting burden for Europe’s companies without compromising financial stability,” Valdis Dombrovskis, the commissioner in charge of financial services, said in a statement. “We are also giving pensions funds a breathing space, so that central clearing solutions can be developed that protect the revenues of future pensioners.”

— With assistance by Silla Brush, John Glover, Stephanie Bodoni, and Svenja O'Donnell

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