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Commission proposal on Euro clearing – the first of many regulatory changes due to Brexit?

Almost a year after the Brexit referendum, but less than two years before the UK’s anticipated exit from the EU on 29 March 2019, on June 13th the Commission unveiled its first substantial legislative proposal intended to prepare the Union for the UK’s withdrawal.
Offentlig sektor Brexit Konkurranse-, EØS- og statsstøtterett

This move could fundamentally alter Europe's financial infrastructure sector, and could deal the UK's financial services sector a heavy blow. Eventually, it may also require customers of London based clearing houses to shift their business to an EU-based clearing house.

The main features of the proposal

The Commission proposal entails more supervisory powers for the European Securities and Markets Authority (ESMA) and itself with respect to clearing of derivatives trades. Under certain circumstances, clearing of EU denominated derivatives may have to be done in a CCP established in the EU. While criticised by a number of financial situations, the fact that the ECB as well as seeming French and German financial markets associations support this proposal is a strong indicator for this proposal becoming law in the not so distant future.

What is clearing and why is it important

The Commission proposes to amend the so-called European Market Infrastructure Regulation (EMIR). A key requirement of EMIR is the obligation for certain derivatives contracts to be cleared through a Central Counterparty (CCP). Clearing a trade through a CCP means that the CCP becomes the counterparty to the buyer and the seller. It guarantees the terms of a trade even if one party defaults on the agreement, and hence significantly reduces counterparty risk. Since the coming into force of EMIR, CCPs in the EU and around the world have dramatically increased their activity. This trend is likely to continue, as further types of trades will come under the clearing obligation going forward.

Currently, most clearing, including of securities denominated in EURO, is done by two CCPs based in London. This is due to the fact that clearing is an activity in which economies of scale are extremely important – the amount of collateral traders have to post with the CCP are much lower if a CCP has a lot of activity in the same asset class. As a result, the Commission has previously recognised that CCPs have an important role for financial stability. For example, in 2016, the Commission proposed a regulation on CCP recovery and resolution, intended to cushion the impact on financial stability of a CCP failure.

What the Commission proposal entails

Generally speaking, the proposal grants greater supervisory powers to the ESMA, a Paris based EU agency. Going forward, national supervisory authorities will exercise their tasks in agreement with ESMA. However, the main change pertains to EMIR's third country regime. Today, CCPs based (and supervised) in third countries are allowed to offer their services in the EU if the applicable regulatory and supervisory framework is deemed "equivalent". Under the current regime, 28 CCPs in third countries have been authorised under the equivalence framework.

The real catch in the proposal pertains to so-called 'substantially systemically important' CCPs. For such CCPs, the Commission, based on a proposal from EMSA, may take a decision that requires a CCP to become authorised under EMIR and establish itself in the EU if it wants to continue offering its clearing services in the Union. Given that the by far largest type of derivative contract - interest rate swaps - are to a very large degree cleared in two CCPs in London, ESMA would presumably consider them as substantially systemically important. In other words, if this proposal becomes law, it is highly likely that this activity cannot be performed in the UK any longer once the country leaves the Union.

What the impact of the proposal could be

There is a lot of speculation as to the impact of such change. That there will be additional costs due to lesser economies of scale, at least initially, appears certain however. In addition, tens of thousands of jobs in London are linked to the clearing of Euro denominated derivatives. If London really were to loose the euro clearing business, this would almost certainly strengthen its rivals in Frankfurt (or Paris). More clearing business in Euro means a more attractive proposition to also clear trades denominated in other currencies. As a result, an implementation of this proposal may in the long run significantly weaken London's role as financial services centre.

For Norwegian businesses, the immediate impact will probably be limited. Any such relocation decision would most likely not become applicable overnight, so that market participants can adapt. But for all those trading derivatives denominated in an EU currency, this is a development to be followed. In the not too distant future, it may be necessary to become a clearing member in an EU based CCP, or at least identify a clearing member of an EU CCP through which transactions can be cleared in the EU.

Next steps and outlook

The Commission proposal will now go to the EU Council and Parliament, which will have to adopt this proposal before it becomes law.