The derivatives central clearing space continues to evolve in post-Brexit world with new road bumps emerging. Lynn Strongin Dodds explores the challenges market participants face this year as the industry seeks clarification on next steps.
The saga of European derivatives clearing is long and winding. The latest chapter revolves around the European Commission (EC) latest attempt to shift clearing from London to Europe. It should be easier now that the UK has left the bloc, but the details are unclear and many market participants are not convinced that the proposals will be beneficial to end users.
Last December, the EC set out proposals for European firms to clear a portion of their euro-denominated derivatives through European clearinghouses or central counterparties (CCPs) from London by June 2025, when the equivalence waiver that allows its banks and money managers to clear trades in the UK expires.
Under the recommendations, banks will have to set up so called active accounts with minimum volume levels at clearinghouses in Paris and Frankfurt, rather than shift trillions of euros of transactions across the channel in one fell swoop. The Commission said 60% of EU firms that are clients of EU clearing members — already had an account with an EU-based clearing house for interest rate swaps, while 85% had one for credit default swaps.
In addition, the measures allow clearing services providers to expand their products range quicker and easier as well as help increase transparency of margin calls.
“At the moment, the proposals are more carrot than stick to shift more clearing into the European Union,” says Christian Lee, partner and head of clearing practice at consultancy Sionic. “They are trying to avoid a Big Bang event and any unintended consequences when equivalence ends in 2025. The approach taken is more gradual and measured.”
The unknowns
There are still many gaps, which in time are expected to be filled in by the European Securities and Markets Authority (ESMA). The biggest question for many is what constitutes a minimum level. One of the main problems is the definition of an active account, according to Kirston Winters, chief risk officer at OSTTRA. “It comes down to scope, calibration and phasing and how that is done,” he adds. “If it is done too aggressively it could be damaging or too weakly, it will not be meaningful.”
These issues were spelt out in an International Swaps and Derivatives Association’s (ISDA) policy paper. It noted that minimum levels based on notional values – the total underlying amount of derivatives trade – would only incentivise shorter duration trades, which tend to be larger, to shift to EU central counterparties (CCPs). Those pegged to trade frequency would simply capture high trade counts with low risk, such as market-making businesses. Levels based on initial margin or standardised risk would incorporate some risk sensitivity but are difficult to calculate.
The other concern is that the new rules could increase costs by requiring banks to maintain two separate accounts for clearing deals. “It would inevitably lead to a more fragmented market and there would be liquidity pools in the UK and the EU,” says Winters. “The result would inevitably be less offsets which could increase costs and risk.”
These views are shared by other market participants such as the European Fund and Asset Management Association (EFAMA), whose members manage close to €30 trillion in assets. It said the objective of maintaining a competitive and efficient clearing ecosystem would be undermined by the proposal to introduce mandated active accounts at EU CCPs. It noted it was against any forced relocation policy as this will have a negative impact from a cost perspective on end-investors.
The trade group said, “Asset managers require a free choice of CCP in order to fulfil their fiduciary duty to act in their client’s best interest and obtain the best investment outcomes. The measures to enhance EU CCP attractiveness should in themselves draw greater clearing activity organically, without the need to introduce an active account obligation.”
ISDA also voiced its worries. “The EC has proposed that firms subject to the EU clearing obligation should have an active account at an EU CCP, while giving ESMA the power to define the portion of certain euro- and Polish zloty-denominated contracts that should be cleared through those accounts via secondary regulation. Changes to capital rules would reinforce this, making it less commercially viable for EU market participants to clear through CCPs based outside the EU,” it added.
The trade group reiterated that these measures, as proposed, would make EU firms less competitive and would have a negative impact on the derivatives market, EU clearing members and their clients, EU investors and savers, and the Capital Markets Union. “For EU firms, this would not only hinder their ability to provide best execution to clients but would also be costly to implement. We believe the EC should substantiate the risk of clearing through tier-two CCPs based outside the EU and provide a robust cost-benefit analysis of the proposed active account requirements,” it said.
Moving parts
Chipping away at LCH, the dominant player in Europe will not be that easy. At the moment, with equivalence in place, the latest figures from Clarus shows that LCH SwapClear dominates with a 95.4% market share, having cleared €14 trn in 2023 Q1 and €13.3 trn in 2022 Q1. However, Europe is a small slice of its overall business as it also clears the overwhelming majority of US dollar products as well.
“We provide firms locally and globally with access to large pools of liquidity across asset classes,” says Julien Jardelot, head of Europe Government Relations and Regulatory Strategy at London Stock Exchange Group (LSEG). This access is essential for them to ensure they can efficiently manage their risks and it also ensures financial stability. It’s important to note that the euro is an international currency – 70% of EUR IRS Interest rate swaps) volumes are originated outside the EU. This demonstrates the importance of EU firms having access to liquid markets.”
By contrast, Eurex, with its domestic bias, has 4.5% of the European market, having cleared €0.66 trn in 2023 Q1 and €0.96 trn in the first three months last year, according to Clarus figures. The German exchange, though, is laying the foundation and late last year launched an incentive programme to support buy-side clients who are starting to clear OTC interest derivatives rates positions in the EU. Eurex launches new incentive program for euro clearing in the EU – Derivsource
Designed for clients running active accounts in the EU, the scheme could qualify participants for an incentive reward of up to 50,000 euros when starting the clearing of OTC IRS, overnight index swaps (OIS), basis swaps and/or zero-coupon inflation swaps (ZCIS) at Eurex Clearing next year.
Matthias Graulich, Member of the Eurex Clearing Executive Board, said, “With this targeted incentive program for buy-side clients, we again demonstrate our strong commitment for a market-led solution which is designed to further accelerate the development of a liquid, EU-based alternative for the clearing of OTC interest rate swaps. Especially against the backdrop of enduring uncertainty, changing rates and an increased need for hedging a broader marketplace through greater choice, improved price transparency, as well as reduced concentration risk is more important than ever.”
Related reading:
2023 Outlook: US Rule Proposals Impacting Swap Dealers and Derivatives Clearing – Derivsource
