In a Q&A with DerivSource, Michael Thomas, partner in the financial services team at law firm Hogan Lovells, discusses ‘Bremir’ and how a Brexit may impact euro denominated central clearing, CCP equivalency as well as the wider issues of global stress testing.
Q. Let’s speak first about EMIR regulation and where we go now with Brexit. What will happen to EMIR and MiFID II? Will the UK continue to implement the regulations or develop its own version which some people are calling Bremir?
A. That is a good question and actually it goes to the heart of the choice that the UK has to make in the post-Brexit environment, and that is either to maintain as much of EU law as possible within its own law, or to go its own way and potentially deregulate elements of the financial services sector, or to develop more UK-oriented requirements that are felt to be more suitable to the UK market.
I think the more likely scenario is that we will in some way incorporate provisions reflecting the requirements of EMIR and MiFID II into UK domestic law, and there are a number of reasons for this.
The first is that some of this law is derived from international agreements at the G20 summit in Pittsburgh in 2009, which provided for the improvement of risk management and clearing of OTC derivatives, which has been enshrined in EMIR. Also common standards for the supervision of CCPs, which again is enshrined in EMIR. MiFID II will again implement requirements that have been agreed at a higher international level in addition to a number of other European-specific areas of focus.
The other issue is that financial institutions in the UK have already had to upgrade themselves to the EMIR standard of regulation. For example, UK CCPs have been through an extensive authorisation process under EMIR and have had to redesign their clearing arrangements to ensure that they are compliant with the requirements under EMIR.
To change the law in order to impose new or different requirements will impose additional cost burdens on the financial services industry in the UK which would arguably be unpalatable to the UK financial institutions, particularly after they have gone through such extensive regulatory change in the past few years.
The other issue is that the more that the UK diverges from EU law, and in particular the more that it diverges from the requirements under EMIR and MiFID II, the less likely it will be that UK financial institutions will be able to benefit from the third country regimes under those regulations. So, for example under EMIR there is a third country regime that permits non-EU CCPs to access the EU to provide clearing services, provided that their home state jurisdiction applies an equivalent regime to that under EMIR for the regulation of clearing houses. There are similar third country access requirements under MiFID II for firms wishing to do wholesale business on a cross-border basis from an equivalent jurisdiction.
So my suspicion is that we will end up with a form of law that incorporates and adapts into UK law the requirements of EMIR and MiFID II. Of course there will be a need to amend those laws to the extent necessary to reflect the fact that the UK is no longer a member of the EU, such as for example the disapplication of any provisions that relate to interactions with EU regulatory bodies such as ESMA, and in the case of MiFID II the disapplication of passporting rights unless and except to the extent that the UK is able to negotiate some form of passporting rights as part of the exit negotiations.
Q. Let’s discuss Euro denominated clearing which has been in the news quite a bit after Brexit. What do you think will happen to that sector?
A.I think that’s a difficult one to answer with much certainty at this point. Clearly there was a move within the European Central Bank (ECB) a couple of years ago to mandate that Euro denominated financial instruments should be cleared by a Eurozone based central counterparty. That policy was taken to court, to the European Courts, by the UK government, and the UK government won in having that policy struck out. And the reason why the ECB’s policy failed is because it didn’t have the power under EU law and under its founding powers to actually impose the policy in the first place.
Now, if we are outside the EU we will have less influence over the formation of policy within the EU as we will no longer be a member with a say at the legislative table and it is entirely possible that the EU may subsequently create the power and give the power to the ECB in order to impose a Eurozone clearing requirement for Euro denominated instruments.
However, I think this is a matter of politics and there will be a focus on our own diplomats and our negotiation team in the Brexit negotiations to ensure that the position of the City and the location for the clearing of Euro instruments is not undermined by changes in policy within the EU itself.
In terms of the structure of the regulation that applies to the clearinghouses, under EMIR,, there is a regime that permits third country CCPs to provide clearing services to EU-based clearing members. This is the third country regime under EMIR. As explained above, this will be subject to an assessment of the equivalency of the UK regime to the regime under EMIR. So there is a mechanism to allow UK CCPs to clear for European clearing members. The question of whether those UK CCPs would be required to comply with any additional requirements to clear Euros or maybe restricted from clearing Euros is potentially a matter for policy and negotiation.
But clearly, the less influence we have within Europe, the less able we are to prevent European regulators and legislative bodies from imposing requirements that may operate to the detriment of the City.
Q. You’ve touched upon some of the challenges of clearing houses post-Brexit. Are there any other challenges you foresee? Will they have to move over to the Continent or use one of their subsidiaries? I know it is early days.
A. Yes, it certainly is early days. I can’t speak for any particular clearing house on this call, but as I said there is a regime under EMIR that enables non-EU clearing houses to provide clearing services to European clearing members, so there is a legal structure there that can be used to preserve the operations of UK CCPs. What will make it difficult is if the EU imposes additional requirements either on its clearing members or on clearing houses accessing Europe more generally. As explained above, for example, they could potentially require Euro denominated instruments to be cleared by a Eurozone based CCP, and if that was to be the case then UK CCPs would need to take a decision either to cease to clear those Euro denominated instruments or to establish a clearing operation within Europe.
It is not an inconsiderable task to establish a new clearing house. The authorisation process under EMIR takes about a year and is necessary to ensure that the clearing house is robust and has all of the services that it needs to support its operations and also that its rules and regulations, clearing arrangements, security taking arrangements and collateral management arrangements are legally enforceable; that its default management arrangements are enforceable against defaulting clearing members. This requires quite a lot of legal work to ensure that all of these aspects of the CCP’s operations hold up in a default scenario.
So maintaining two clearing houses in the UK and in the European area will present cost and logistical challenges. There will of course be a need for the clearing houses to continue to service the markets that are not subject to any new EU requirement that requires a Eurozone based clearing house, such as for example they’ll need to continue to service the UK markets.
However, we will need to see what the precise change in the legal regime is before determining whether it is appropriate or necessary to establish another presence within Europe.
Q. Speaking of CCP equivalency, it took about 4 years for the EU and US to agree, and they had different models. Do you have any idea whether the UK may move more to the US original model, or will they keep to the EU model? And will it take as long as it did with the US if the UK has to agree on equivalency?
A. I think it’s more likely that the UK will continue with the EU based model rather than to change its clearing requirements to align more closely to the US clearing model. That is because there are a number of different reasons: one is that the UK is currently applying the European clearing model under EMIR, but also the way the UK and European markets work in clearing arrangements are very much based upon the principal clearing model whereas the US does allow for different types of clearing structures.
The current model in the UK is the one that UK clearing firms (like clearing members and firms that are using UK clearing houses) are familiar with.
In terms of how long it would take to establish equivalency arrangements with the US for UK CCPs, well that really is a matter of speculation. We don’t know, but presumably, or hopefully, if the UK maintains equivalent arrangements to that which were maintained under EMIR, then given the fact that the US and the EU have agreed equivalency arrangements in their recent negotiations, that that provides a model for the establishment of equivalency arrangements between the UK and the US.
If we diverge significantly from the European requirements so as to create our own clearing regime, then of course the relevance of the EU / US negotiations becomes less significant.
Q.Looking beyond EMIR, what would happen to the Banking Recovery and Resolution Directive (the BRRD)? If the UK repeals it is there something to take its place or do you think it would it be better to keep it?
A.The BRRD is implemented in the UK. If the UK was to leave the EU then the application of the BRRD would depend upon whether the UK remained within the European Economic Area. If the UK did not join the European Economic Area then it would become a third country for the purposes of BRRD and EU member states would become third countries for the purposes of the UK Banking Act, 2009.
So, one of the consequences of the UK being a third country is that in accordance with Article 55 of the BRRD, known as the Bail-in Provision, financial institutions regulated in the EU which incur liabilities under English law contracts, will have to seek the inclusion of contractual recognition of bail-in clauses in those English law contracts.
Now, I do not see any good reason why we wouldn’t implement or maintain in the UK provisions that are equivalent to those that are BRRD. It is law which the UK has been instrumental in helping the EU to develop, and so I think that it would be sensible for the UK to continue to replace and remain with BRRD-based provisions.
Q. The last question is a wider question: in May, the Bank of England called for global stress testing to stop CCPs from becoming too big to fail. Is this a possibility and what are the current rules at the moment?
A.At the moment, the Bank of England requires its own CCPs to conduct stress testing of their margin methodologies and their risk management processes. This is consistent with the requirements under EMIR. In relation to global stress testing, I think the issue is whether there will be consistent standards for the stress testing of CCPs in the key jurisdictions around the world.
Clearly, CCPs are systemically important organisations, and the more markets that a CCP supports the more that it becomes systemically important to those markets, because if a CCP were to fail then the market it supports will be significantly hampered from being able to operate. Indeed, in some markets the absence of a CCP will mean that the market cannot operate at all.
So there is a legitimate argument for ensuring that CCPs with reach into multiple jurisdictions around the world should be assessed by common standards in terms of their risk management arrangements and their ability to withstand shocks to their operations.
However, that will require international cooperation. Whilst we’ve seen that agreements have been made at an international level such as through the G20 commitments to, for example, improve the risk management and clearing of OTC derivative contracts, the way in which those requirements have been implemented in different jurisdictions; whether the US or the EU or in Asia, are different in each jurisdiction. So to ensure that there is a truly harmonised international regime for stress testing of CCPs it will require some form of international coordination.
There is a precedent for this in the sense that the CPSS / IOSCO requirements for financial market infrastructure do provide a template for the establishment of common standards in different jurisdictions for the supervision of market infrastructure such as CCPs. To the extent that there is a drive for global stress testing arrangements, I think organisations such as CPSS / IOSCO will be key in ensuring that there is a common template for establishing those stress testing requirements.
Who performs the stress test I think is another question. I think that the primary responsibility ought really to be on the domestic regulator of the CCP, but of course there needs to be proper exchange of information between regulators of the CCP and those of the markets that the CCP supports.
To hear the interview, please go to the recent DerivSource podcast.
