Clearing the Euro: Temporary solution only on offer in a no-deal Brexit

Introduction

This article was originally published in the February 2019 edition of the Journal of International Banking and Financial Law.

Nature abhors a vacuum and even more so sophisticated financial institutions, financial markets and the European Commission. The remaining uncertainty as the UK struggles to finalise an agreement on leaving the EU means that firms must continue their planning based on a “no-deal” scenario. Indeed, the European Commission has begun preparations for a no-deal Brexit.

Even if a withdrawal agreement is finalised with a transitional period, this merely postpones the inevitable. As such, firms and financial institutions must continue contingency planning regarding the implications and arrangements around clearing and settlement of euro-denominated products.

On December 19, 2018 the European Securities and Markets Authority (ESMA) issued a statement to remind firms of their MiFID obligations on disclosure of information to clients in the context of the UK withdrawing from the EU. The message is clear: don’t wait, act now.

Brief summary

• Following the global financial crisis, the EU extended the obligation to clear centrally from regulated markets to derivative transactions on over-the-counter markets by introducing the European Market Infrastructure Regulation (EMIR). Clearing is done by a central counterparty (CCP) interposing itself between the contractual counterparties (to absorb risk of default spreading through the market), becoming the buyer to every seller and the seller to every buyer.
• The City of London is the leading global player in trading and clearing derivatives: more than US$450tn of swaps and futures deals are processed through London. Meanwhile, London dominates the processing of euro-denominated interest rate swaps, with 75 per cent of these cleared in the UK. The Bank of England has estimated that about GBP 41tn of these contracts will be affected by Brexit.
• EU rules stipulate that the bloc’s banks can only use authorised clearing houses. Significantly, those in London would lose this status in the event of the UK exiting the EU in March without a withdrawal deal. Under the EMIR II proposal,¹ Euro-denominated clearing may only be allowed under the direct supervision of ESMA.
• On December 19, 2018 the European Commission adopted acts to limit immediate disruption in the cross-border derivatives market in a no-deal scenario.

The position of the European Commission

The Commission adopted the following limited contingency measures to safeguard financial stability post-Brexit:

• “A temporary and conditional equivalence decision for a fixed, limited period for 12 months to ensure that there will be no immediate disruption in the central clearing of derivatives”;
• “A temporary and conditional equivalence decision for a fixed, limited period of 24 months to ensure that there will be no disruption in central depositaries services for EU operators currently using UK operators”;
• “Two Delegated Regulations facilitating novation, for a fixed period of 12 months, of certain over-the-counter derivatives contracts, where a contract is transferred from a UK to an EU27 counterparty.”

So what happens now?

• The above three limbs underline the statement made by Valdis Dombrovskis, the European commissioner responsible for financial regulation, that a temporary solution would be based on EU market access rules, known as “equivalence” standards, to grant short-term approvals to UK-based clearing houses. Until a permanent fix is agreed, banks will have to decide whether to shift thousands of contracts to one of the remaining 27 EU member states or to countries that meet EU standards.
• ESMA has stated that it would begin the process of temporarily “recognising” clearing houses in the UK so they could continue clearing derivatives trades for EU customers after Brexit if no transition is in place and was given the green light to do so by the European Commission in November to do so.
• Eurex, owned by Deutsche Börse, has set up a rival scheme for banks to clear their portfolio of euro-denominated interest rates in the EU – it is now clearing a notional EUR 9.3tn of contracts but it is estimated that two thirds of this business is in forward rate agreements, which is short-term and low margin. Meanwhile, Société Générale is opening a Paris hub to clear derivatives in the European Union. The new unit joins several clearing houses, including the London Stock Exchange’s LCH SA in Paris and Deutsche Börse’s Eurex Clearing in Frankfurt.
• The lucrative and substantial business between dealers and their end customers remains with LCH, although many expect the increasing uncertainty will increase connectivity to Eurex and increase its market share. Michael Werner, an analyst at UBS, forecasts that a quarter of the higher margin, dealer-to-customer business would shift to Eurex by 2020. Crucially, if there is no equivalence deal, that would shift immediately. At the same time, he expects EU customers deprived of LCH would also pull their US dollar-denominated business from London and transfer it to CME Group in the US.
• The Commodity Futures Trading Commission has issued several staff letters to Eurex, providing an additional safeguard for US banks to funnel trades from hedge funds or big institutional investors via Frankfurt. The US authorisation intensifies the competition between Eurex and LCH.

The Message is clear: Relocation of Euro clearing is in progress

The obvious: similar to in 2011,² the European Commission and the ECB ultimately want to see more euro-denominated clearing located in the Eurozone under the bloc’s direct supervision under the ESMA, once Britain becomes a non EU state. Equivalence in the transitional period prevents immediate disruption in the central clearing of derivatives, yet transitional periods are temporary by nature.