Wednesday, June 07, 2017

FIA warns European Commission not to require euro-denominated derivatives to be cleared in E.U.

By Lene Powell, J.D.

In a letter to the Vice President of the European Commission, the derivatives association FIA strongly cautioned against possible Commission plans to require relocation of euro-denominated derivatives clearing to the E.U., saying this would reduce liquidity and increase systemic risk. Such a move could also increase costs for derivatives end-users, nearly doubling margin requirements from $83 billion USD to $160 billion USD, said FIA.

Brexit and forced relocation. In a Communication on May 4, 2017, the Commission said it will present legislative proposals in June relating to the safety and soundness of central counterparties (CCPs or clearing firms). The Commission is considering strengthening supervisory functions and the responsibilities of the central bank of issue at European level. The Commission noted that after the anticipated withdrawal of the United Kingdom from the E.U., a substantial volume of transactions denominated in euro and other Member State currencies would no longer be cleared in the E.U., so would no longer be subject to EMIR and E.U. supervisory architecture.

The Commission said that where CCPs play a key systemic role for E.U. financial markets and directly affect the responsibilities of E.U. and Member State institutions and authorities, specific arrangements based on objective criteria will be necessary to ensure that CCPs are subject to safeguards under the E.U. legal framework. Safeguards would include, where necessary, enhanced supervision at E.U. level and/or location requirements.

In FIA’s letter to Vice-President Valdis Dombrovskis, FIA President and CEO Walt Lukken said the association has “grave concerns” that the forced relocation of clearing of euro-denominated derivatives to the E.U. would fragment markets, raise costs for end users, and weaken the stability of the financial system.

Market fragmentation, higher costs. According to FIA, forced relocation may fragment markets, creating two distinct pools of trading liquidity. Currently, 75 percent of the LCH SwapClear Euro-denominated interest rate swaps do not have E.U. counterparties. Forced relocation might create an offshore pool for the majority of euro-denominated swaps that are traded by foreign institutions, and a much smaller and less liquid onshore pool for swaps traded by E.U. institutions.

Market fragmentation would “most certainly” increase costs for end users, said FIA. Risk offsets will be lost and end users will have to post more margin to accommodate this heightened risk. A report by Clarus Financial Technology estimates that margin requirements would rise by as much as $77 billion USD, nearly doubling the amount of required margin to $160 billion USD.

FIA said that E.U. end users would also face higher execution costs due to lower volumes and fewer participants in the marketplace. In addition, clearing firms could pass on increased costs due to increased capital requirements resulting from bifurcation of the clearing pool.

More systemic risk. Market fragmentation could make it harder for CCPs to port or auction positions of a defaulting clearing member, making it more difficult to recover from a systemic crisis. A location policy could make it too expensive for some clearing firms to set up separate clearing services for onshore and offshore clients, and firms may decide against providing clearing for E.U. clients. This could exacerbate the trend of a decline in the number of clearing firms, further concentrating risk in fewer clearing firms and raising concerns about the market’s ability to absorb clients of a defaulting clearing member.

According to FIA, forced relocation would be the most disruptive and expensive approach, yet would not improve oversight. The association observed that other reserve currencies do not currently have a location policy. About 90 percent of the U.S. dollar-denominated interest rate swap market is cleared outside the U.S., and Canada and Australia at one time considered imposing location requirements for derivatives denominated in their currency, but both ultimately rejected the idea. For the euro to maintain its status as one of the world’s great reserve currencies, it should be traded freely and openly, and policymakers should proceed with caution in imposing any restrictions, FIA said.

Recognition and enhanced supervision. FIA favors the Commission’s suggestion of recognition and enhanced supervision, and believes the E.U. system of equivalence of third-country CCPs currently provides the necessary tools for ongoing information gathering, inspections and oversight. FIA pointed out that equivalence determinations under EMIR are comprehensive and require cooperation agreements between ESMA and the relevant competent authorities of the third-country.

But if the Commission finds it necessary to increase oversight of third-country CCPs, FIA urged that any increase in powers should be carefully calibrated. Other jurisdictions have used both recognition and direct supervision in their oversight of third-country exchanges and CCPs. The association pointed to the U.S. CFTC’s tailored approach, which provides for exemptions in certain cases, including for certain third-country CCPs that clear only the proprietary positions of U.S. institutions.

In conclusion, FIA believes that forced relocation would be unnecessary and detrimental to the economic interests of the E.U., and that supervision can be enhanced to meet the needs of the E.U. supervisors.