Location of central counterparty clearing houses (CCPs) has been a big bone of EU-UK contention since the start of the Brexit discussions, and is the only domain where equivalence is still in place. Since the financial crisis, and the obligation to centrally clear over-the-counter (OTC) contracts, the central role of CCPs has grown enormously, creating concerns about financial stability and adequate supervision of these entities. With the departure of the United Kingdom (UK), the European Union (EU) would prefer to move these entities to the EU, to reduce exposures to a non-EU and a non-euro country. But forced relocation would damage the competitive position of European banks, and make their participation more expensive in global CCPs. Developing CCPs in the Europe should be part of a long term effort to develop the EU’s capital market.
Derivatives markets have grown significantly over the last two decades. The global aggregate size of the OTC and exchange-traded derivatives markets grew from €78 trillion to €528 trillion between 1998 and 2020, in terms of notional amounts outstanding. The OTC segment accounts for 90 % of that, of which interest rate derivatives (IRD) make up the vast majority (80 %). Central clearing in derivatives markets has advanced enormously since the global financial crisis and the G20 commitments (in particular the requirement that all standardised OTC derivatives should be centrally cleared). From 2008 to 2020, the share of derivatives contracts that were centrally cleared rose from 50 % to 83 %, while for certain asset classes like IRD it reached 91 %.
In an EU context, the largest derivatives CCPs developed in the City of London, a leading global central clearing hub of OTC derivatives of all asset classes and currencies. Currently, three UK-based CCPs dominate the (European) market for swaps and futures clearing. More than €3.2 trillion notional outstanding of interest rate swaps (IRS) are cleared in the City of London per day across all currencies, and about 94 % of all euro-denominated IRS are traded globally. On the other hand, EU-based CCPs account for 6 % of the global euro-denominated IRS market.
A stake for policymakers
Concern about the risk in CCPs and foreign currency exposure has been an issue among EU policymakers and supervisors for the last two decades. However, and since the departure of the UK from EU, these concerns have been intensified. European policymakers have encouraged EU clearing members and market participants to reduce their exposure to systemically important (SI) UK CCPs, while at the same time they are persuaded to further develop EU’s derivatives clearing capabilities. Potential benefits of increased use of EU CCPs could include cross-product netting with listed derivatives, which could promote trading within the EU. This could also stimulate the creation of legal, economic and operational expertise that could spur the development of EU financial centres.
Ensuring that financial stability risks are adequately managed and that EU financial institutions that participate in UK CCPs are sufficiently protected, is the EC’s primary task. As such, EMIR 2.2 was introduced as a means to enhance the EU framework for the supervision of third-country CCPs. The direct application of EMIR standards to systemically important CCPs, and the direct involvement of ESMA (and EU central banks) in monitoring and supervising recognised third-country CCPs, resolves some of the policy issues raised by the heavy reliance of the EU financial system on services provided in London.
The danger of the two marketplaces
However, UK-based CCPs serve a global market, not only a European one. A requirement by EU authorities for EU-based firms to move away from UK CCPs will restrict those firms’ access to liquidity, increase their clearing costs and negatively affect the competitive position of EU companies internationally. It will create two distinct marketplaces, one for EU firms and another for non-EU firms, which will disadvantage EU banks compared to their international counterparts. It will become more expensive for EU-based operators to clear their positions at UK CCPs, and will impact their client-clearing and market-making activities with non-EU clients and counterparties. At the same time, non-EU banks will preserve their ability to offer their services to non-EU clients and counterparties.
Furthermore, location policies have been considered in the past in other jurisdictions than the EU, but these were either abandoned as a policy option or drastically scaled down. In Australia and Canada, for example, regulators decided instead to strengthen cross-border regulatory cooperation with third countries, given the liquidity and resilience benefits provided by global CCPs. In Japan, on the other hand, the requirement for Japanese entities to clear their home currency-denominated IRD through a local CCP has effectively resulted in these entities being restricted to the local liquidity pool. It has thus created fragmentation between the activities of Japanese banks, which clear through the local CCP, and global banks, which typically clear through a global CCP.
The different solutions
In the short term, the best way forward to address potential EU concerns around the exposure of EU firms to UK CCPs is to implement appropriate supervisory and regulatory cooperation between both jurisdictions. Adequate arrangements exist in general provisions and in the specific rules of the EU’s European Market Infrastructure Regulation (specifically EMIR 2.2) to ensure orderly cooperation between the EU and the UK, and to allow for hands-on supervision by the European Securities and Markets Authority of UK-based CCPs deemed systemically important to the EU. Moreover, central banks – the Bank of England, the European Central Bank and other Central Banks of Issue – are fully involved in the supervisory structure and form part of the supervisory colleges. The new supervisory structure needs to be given time to function properly before any more radical changes are introduced, given their significant potential negative consequences on EU firms.
Any EU policy to further develop central clearing in the EU should be part of a clear long-term strategy in the context of the Capital Markets Union (CMU). The current concentration of derivatives clearing in the UK has developed over a long period as part of the single market, and thus – even if pursued as an EU policy objective – restricting access by EU firms cannot be achieved easily, or without collateral damage for EU banks and end users. Moreover, central clearing is integrally connected with other building blocks of a large financial centre, such as the presence of intermediaries and end users, widespread subject matter expertise, a suitably adapted legal framework and strong underlying infrastructures.
EU market participants should be able to retain the flexibility to continue to clear their transactions through the CCP of their choice or the choice of their clients and counterparties, and benefit from access to global pools of liquidity and product ranges that meet their needs. This is even more the case when their regulatory and supervisory regimes are equivalent to the EU one. Enabling participants in the marketplace to determine the optimal market structure based on their trading needs and objectives will allow for a more organic, market-led and customer-driven development of EU derivatives market infrastructure. This will keep the EU financial markets open, global and attractive, while strengthening the international role of the euro.
