Photographer: Simon Dawson/Bloomberg

EU Targets Derivative-Clearing Giants With Relocation Threat

  • Proposal could impact London-based firms as Brexit talks loom
  • European Commission unveils overhaul of market infrastructure

The European Union could force the biggest foreign derivatives-clearing firms to set up shop in the bloc if they want to continue doing business there, as policy makers brace for the changes Brexit will bring to an industry in which London plays a key global role.

The European Commission on Tuesday proposed a two-tier system for non-EU clearinghouses. Smaller firms would carry on operating under existing rules, while those deemed systemically important to European financial markets would face stricter scrutiny and, ultimately, could be forced to move clearing of EU derivatives inside the bloc.

This so-called location requirement spurred warnings from the industry of skyrocketing costs and loss of jobs in London. It has also helped to turn clearing into a political football as the EU and U.K. prepare for divorce negotiations that are set to begin next week.

“I do not believe that the EU has any real desire to impose these costs on euro-zone banks,” Simon Gleeson, a regulatory partner at Clifford Chance, said before the proposals were published. “Consequently I think what is really going on here is the EU trying to create a bargaining chip that it can employ to get a more substantial say in the way that London clearing is regulated post-Brexit.”

CCPNotional amount outstanding of euro-denominated OTC interest-rate derivatives Euro market share
LCH Ltd (Swapclear)$84.3 trillion97%
CME U.S.$1.8 trillion2%
EurexOTC$0.9 trillion1%
Source: European Commission

Clearinghouses stand between the two sides of a derivative wager and hold collateral, known as margin, from both in case a member defaults. About 75 percent of trading in euro-denominated interest-rate swaps takes place in the U.K., according to Bank for International Settlements data from April 2016.

“Today, a significant amount of financial instruments denominated in the currencies of the member states are cleared by recognized third-country CCPs,” according to the proposal. “For example, the notional amount outstanding at Chicago Mercantile Exchange in the U.S. is 1.8 trillion euros for euro-denominated interest-rate derivatives,” the commission said. “This also raises a series of concerns.”

Brexit Puts Financial Clearing Work Up for Grabs: QuickTake Q&A

The financial industry has lobbied hard against a location policy. The International Swaps and Derivatives Association said requiring euro-denominated interest-rate derivatives to be cleared by an EU-based clearinghouse would boost initial margin requirements by as much as 20 percent. The FIA, a trade organization for the futures, options and centrally cleared derivatives markets, has said forced relocation “could nearly double margin requirements from $83 billion to $160 billion.”

The commission’s proposal foresees relocation only as a last resort for the biggest firms, however. It sets out a “gradual sliding scale of supervisory requirements” that will avoid “excessive costs” for firms.

“While this option may trigger certain additional costs at institutional level and for third-country CCPs, and ultimately for market participants, such costs have to be weighed against the gains in systemic risk mitigation, although the exact monetary benefits of a reduction of systemic risk are difficult to quantify in advance,” according to the proposal.

Valdis Dombrovskis, the EU’s financial-services policy chief, said the point of the proposal was to boost financial stability, not to force businesses to move. “This is why we are not putting forward some kind of a generalized location requirement,” he told reporters.

‘Collateral Damage’

EU policy makers have been outspoken about the need to retake control of euro-denominated derivatives clearing in particular. German Finance Minister Wolfgang Schaeuble said last month that the “major part” of euro clearing should be inside the EU. Not everyone is convinced that a location requirement is the best solution, however. Felix Hufeld, the head of German supervisor BaFin, has cautioned against the policy, saying that it could trigger protectionism and create “collateral damage.”

Under the commission’s plan, non-EU clearinghouses of systemic importance to the bloc would have to comply with the “necessary prudential requirements” faced by their EU peers. The relevant central bank could impose additional rules on margin or liquidity arrangements, and EU supervisors would have on-site access for inspections. The location requirement will be restricted to a “limited number” of companies for which the other measures in the proposal are deemed insufficient to “mitigate the potential risks.”

The proposal grants the European Securities and Markets Authority powers to determine when clearinghouses qualify for more stringent oversight. This could be accomplished by their home-country regulator if ESMA agrees that the level of oversight there is comparable to that in the EU.

ESMA has pushed for a greater role in policing non-EU firms’ access to the single market, including supervision and enforcement for credit rating agencies, trade repositories, central counterparties and benchmarks.

Tuesday’s proposals are part of an overhaul of the EU’s market-infrastructure law, which sets out rules for over-the-counter derivatives, central counterparties and trade repositories. The criteria that will be used in classifying clearinghouses will be spelled out later in implementing legislation.

Markus Ferber, a German lawmaker in the European Parliament, said the commission’s plan showed it “lost its courage” on euro clearing. “We do not need a case-by-case analysis, but one clear rule,” he said. “The rule must be that euro clearing must be done under EU jurisdiction, no ifs or buts.”

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