The Case for Stability in Euro Clearing



ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

Over the past year, the coronavirus pandemic and Brexit have presented derivatives markets with their greatest test since the financial crisis. While the market has proved its resilience, the prospect of a forced relocation of derivatives clearing from the UK to the EU poses a further threat of disruption and fragmentation.

As it stands, EU firms have been able to clear at UK central counterparties (CCPs) following the end of the Brexit transition period, thanks to a temporary equivalence determination granted in September 2020. However, that equivalence decision is due to expire in mid-2022, and the European Commission (EC) has made it clear there won’t be an extension. In the interim, EU institutions have been told to reduce their exposure to UK clearing houses.

Now, ISDA is all for safe, efficient markets, and within those parameters, we are agnostic on where market participants choose to clear their trades – but that decision should be left to the firms themselves. Creating a situation where market participants are forced to relocate exposures by a set date has important systemic risk, market function and competitive implications that will impact EU financial institutions and their clients the hardest.

Any compulsory relocation would require existing trades to be closed out and new contracts opened at EU CCPs, but it is unclear whether the market is deep enough for this to occur without disruption. As forced buyers and sellers, the migration would come at considerable cost to EU firms and would involve huge operational complexity.

The resulting fragmentation would also have a competitive impact. Only 25% of euro interest rate derivatives clearing volume has an EU 27 nexus and could be required to relocate to the EU. This essentially means EU institutions would be unable to access the biggest global liquidity pool, which would continue to reside outside the EU, potentially resulting in higher prices for EU end users. In addition, not all contracts cleared by UK CCPs are currently offered by EU clearing houses.

A clearing location policy might also have broader consequences. It could hinder the objective of the Capital Markets Union to provide an integrated market for EU companies to raise capital by making hedging more expensive and less effective. It could also thwart the international role of the euro, which requires that the currency can be traded globally and that euro investments can be efficiently hedged.

ISDA has long made the case for supervisory cooperation for CCPs, but fragmentation in markets quickly leads to fragmented supervision. The European Market Infrastructure Regulation 2.2 has created a strong supervisory framework that gives European authorities effective oversight and powers over third-country CCPs. It is also positive that CCP resolution regimes in the EU and UK are closely aligned.

However, a forced relocation of clearing could diminish the European Securities and Markets Authority’s prominent role in the oversight of UK CCPs. Should clearing business move to the US, it will have even less oversight.

At this critical time in the recovery from the pandemic, it is imperative we do not introduce additional risks and costs. Forcing EU counterparties to use EU CCPs, either by letting the existing equivalence period expire or by introducing a new mandate, would be hugely disruptive, risky and damaging to the interests of EU firms. Such disruption should be avoided. The EU can support and strengthen EU CCPs without enforcing a location policy, so we urge the EC to grant permanent equivalence to UK CCPs.

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