Despite the European Commission’s best efforts, some 90% of euro-denominated clearing volumes still take place in the UK. The European Commission recently conferred a time-limited third country equivalence to UK CCPs, leaving open the option to force firms to shift clearing volumes to the continent when that equivalence expires. In a recent webcast, panellists from BNP Paribas, Deutsche Bundesbank, Deutsche Börse, Eurex and BMO Global Asset Management discussed the ongoing shift to euro-centric clearing and the regulatory and operational challenges and opportunities it presents.
As tensions continue to rise between the EU and the UK in anticipation of the Brexit deadline, the European Commission (EC) announced in September that temporary third-country equivalence would be granted to UK central counterparties (CCPs) for 18 months. In the same month, European Securities and Markets Authority (ESMA) confirmed LCH and ICE Clear Europe Ltd would be recognised as third country CCPs (TC-CCPs) and Tier 2 starting January 1 2021 and LME Clear Ltd is deemed Tier 1. ESMA also confirmed that In line with the equivalence decision, the recognition decisions will only apply while the equivalence decision remains in force, which is until 30 June 2022. The 18 months provided for by the time-limited decision gives ESMA the opportunity to conduct a comprehensive review of the systemic importance of UK CCPs and their clearing services or activities to the Union. Currently some 90% of euro-denominated derivatives are cleared by a single UK CCP and the EC has long wanted to bring that clearing under its supervision. Brexit has intensified the issue, but the desire to locate euro clearing in continental Europe predates the 2016 EU referendum.
“While equivalence has been granted for now, the wording in the equivalence decision was harsher and more politicised than before and the EC has made it clear that their extensive review of the systemic importance of UK CCPs could lead to non-recognition and relocation requirements when the review period ends,” says Niels Brab, Head of Group Regulatory Strategy/Government Relations & Political Affairs, and Chief RegulatoryOfficer, Deutsche Börse.
“A temporary third country equivalence decision makes sense given the UK government’s stated intention to diverge from EU regulation and supervisory framework,” says Matthias Schmudde, Head of the Payment and Securities Clearing and Settlement Division at Deutsche Bundesbank. Interpreting the announcement, Schmudde says: “EU market participants are urged to reduce their reliance on third party, third country market infrastructures like UK CCPs byJune 2022. And accordingly, the EU CCPs should develop further capacities to accommodate new business.”
EU eyes levers for shifting Euro clearing to Europe
The EC hopes EU-based market participants will voluntarily move their euro-denominated derivatives portfolios to be cleared on the continent with the application of three levers:
- The threat of a regulatory mandate
- Supervision of EU supervisors on EU institutions and a requirement to balance activities between London and the EU
- Encouraging EU public and semi-public institutions to clear more derivatives today in the EU versus the UK
If these voluntary measures do not result in shifting clearing volumes away from London, the EC’s plan B in 18 months may be to introduce a regulatory mandate.
“Open competition should always be favoured, especially between market infrastructures, to foster innovation and avoid inflation in costs for market participants. Voluntary balancing of business between the different liquidity pools is thus preferable, with relevant incentives. It is however important that the possible mandate is fit for purpose as a plan B; further work is needed to define an effective regulatory framework,” says Gaspard Bonin, Deputy Global Head of Derivatives Execution & Clearing, BNP Paribas.
As a leader in market-making and clearing of euro-denominated derivatives, BNP Paribas has been working closely with Frankfurt-based clearing infrastructure provider Eurex to offer full open access to its clients across all liquidity pools, with the same quality of service.
Eurex looks to boost its market share
For clearing volumes to shift, market participants need to see Eurex as a sustainable alternative to LCH, which means Eurex needs to grow its euro clearing market share and keep costs down. Notional outstanding for euro-denominated OTC interest rate derivatives including interest rate swaps (IRS) in October 2020 was 18.9 trillion — an 18.7% EUR market share.
“Notional outstanding in long-dated EUR IRS stands at around 8 trillion, representing a 14.7% EUR market share, and this is growing by ½-1% each month. This is what Eurex really pays attention to as it reflects where the end clients are building their positions over the long term,” says Philip Simons, Global Head of Sales, Fixed Income Derivatives Funding & Financing, Eurex.
Currently, Eurex has 35 partner banks out of 89 clearing members that are incentivised to provide services to end clients. There are some 82 ETD members, 154 repo members, and many firms have membership of all three asset classes enabling them to benefit from an integrated model that is more efficient for margin financing, Simons says. On the buy side, Eurex has well over 400 separate end clients and provides a global service and liquidity through partnerships in the US and Japanese markets.Market demand for inflation swaps is growing and Eurex is working with buy and sell-side firms to provide liquidity, although this takes time, he adds.
With the Brexit deadline approaching, many firms are now looking to transfer entire portfolios with thousands of individual line items, and high-profile transfers done by firms such as DekaBank, with BNP Paribas and others are helping to pave the way. Come January 1, 2021, EU end clients will need to execute with an EU entity and mass re-paperings are ongoing as clearing members transfer the positions of their EU clients to their EU membership, says Simons. At the same time as switching clearing counterparties clients could also take the opportunity to switch any cleared positions from UK to EU CCP’s.
The view from the buy side
BMO Global Asset Management was among the first buy-side firms to implement a move from LCH to Eurex. The firm began its Brexit contingency planning in 2016 and had resolved all the operational, compliance and legal issues of onboarding by March 2019.
It took BMO six months to onboard with Eurex, because of significant operational and onboarding differences between Eurex and LCH. In this regard, BMO GAM was a trail blazer, working with Eurex to help iron out some of the kinks and streamline the process for future firms. However, although onboarding has become more efficient, there is now a large number of firms trying to onboard at the same time, which slows things down. “When we commenced onboarding, we were one of the few, and as such we received a higher degree of focus and assistance from both the clearing members and Eurex as to the operational and legal requirements. If you are one of many, it simply becomes more challenging,” says Rosa Fenwick, Director, LDI Portfolio Manager, BMO Global Asset Management.
The two main considerations before implementing their move were the depth of the market and transaction costs but the firm also benefited from a positive CCP basis, or price differential between contracts, whilst onboarding. “When we moved, we had the advantage of the basis — which outweighed the transaction costs, such that it actually resulted in a net benefit. This made it simpler not just from a hurdle perspective but also for clients to understand and appreciate — they were essentially getting paid for their Brexit contingency plan,” says Fenwick. Now that incentive of a positive basis has gone, firms need to put a strategic decision in place. “If they are not prepared to do it now, an alternative is to be ready and operationally set up to opportunistically take advantage of small movements in the basis which may be beneficial to their transition,” she says. Simons adds: “With the Eurex-LCH basis now stable at +/- zero and high liquidity at Eurex Clearing in OTC interest rate swaps, there is very limited risk and cost associated with switching and so more firms are now considering doing this.”
Whether it comes to a mandate or not, firms that trade in euro-denominated derivatives will eventually need a clearing relationship in the EU. When they make the move will depend on the firm, but firms should be mindful of the fact that there may be an onboarding backlog as the Brexit transition ends and the time-limited equivalence runs its course.
*This article is based on a Eurex webcast entitled: “Post-Brexit Euro Clearing – regulation and the long-term outlook for trading and clearing”. To watch replay, please click here