The European Commission’s (EC) proposal suggests splitting non-EU—or third country—central counterparties (CCPs) into two camps: The first would consist of smaller CCPs and be able to use existing equivalence arrangements, while the second would comprise systemically important CCPs. These will be subjected to enhanced supervision owing to their importance, and the EC further suggests that such entities may need to relocate within the EU to continue to offer clearing services in euro-denominated instruments.

A clearing specialist at a major US bank says the new rules would have a major effect on clearinghouses—in terms of technology lift—if CCPs are required to relocate to the continent, describing it as a “Herculean” task with “massive potential for disruption.” Clearinghouses handle trillions of dollars in trades on a daily basis, and are heavily dependent on technology to complete tasks such as netting, compression and reporting. Even a day’s disruption could have severe consequences if handled incorrectly.

Others point to worries that the new rules would do more harm than good. “On the back of the political debate and negotiations, there are of course very practical questions of mutual recognition and licensing, access rules, the potential risk of fragmentation of liquidity, as transactions are distributed among CCPs, and the allowance for market competition for clearing,” says Roger Storm, head of clearing services at Zurich-headquartered SIX Group.

The move is a blow to the UK, which is home to some of the largest global CCPs. This includes LCH, which historically stood for London Clearing House, and the Intercontinental Exchange (ICE) Group’s ICE Clear Europe, although LCH does have a Paris-based CCP already. ICE declined to comment.

“Regulatory cooperation, which the UK currently enjoys with the US, supports financial stability across the entire market, and provides substantial economic efficiencies for customers, and hence for the real economy, as well,” says a spokesperson for the London Stock Exchange Group (LSEG), which owns LCH. “A location policy does the opposite—it increases, not decreases, risk and costs for customers. Given these facts, European and global customers have overwhelmingly expressed a clear preference for shared regulation between the EU, the UK and the US.”

The decision to potentially force a relocation of clearing to Europe has been met with marked opposition from the industry. The International Swaps and Derivatives Association (ISDA) said on Monday, June 12, that such a move could increase initial margin costs by 15 to 20 percent, while LSE CEO Xavier Rolet has warned that it could cost up to €100 billion ($112 billion).

There are also legal complexities involved that would require a vast amount of effort to remedy, which become pertinent given the nature of CCPs as middlemen in the derivatives market. CCPs act as a seller to every buyer and a buyer to every seller, guaranteeing the trade in the event that one party defaults. This is accomplished by a process called novation, where the original trade is torn up once it is submitted to the CCP, and two equal and offsetting contracts are then entered into directly with the clearinghouse on each side of the trade.

“Besides the people, infrastructure and technology issues, there are other practical realities,” says Steve Grob, director of group strategy at Fidessa. “What language will the contracts be printed in, and will they be enforceable under German or French legal regimes, which have different bankruptcy laws? This will all take time to sort out.”

However, it is likely to benefit Frankfurt-based Eurex Clearing, part of the Deutsche Börse Group, which recently abandoned a proposed merger with the LSE after the EC blocked it on antitrust grounds. Eurex competes with both ICE and LCH for market share in derivatives clearing, albeit in slightly different areas.

“We understand the concerns of European regulators, central banks and politicians who want to ensure effective supervision and access to the full set of recovery and resolution tools for systemically relevant market infrastructures within the EU,” Eurex Clearing CEO Erik Müller tells WatersTechnology.

Carrots and Sticks

The European Securities and Markets Authority (Esma) will be responsible for determining which tier CCPs fall into, and thus whether they are in scope for the enhanced supervisory requirements. A dedicated committee for all CCP matters will also be formed within Esma, which can make a recommendation to the EC that a systemically important CCP should be established within the EU—rather than outside it—if financial stability concerns warrant such an approach.

“Overall, we support the EC reviewing how CCPs are supervised in the EU, given their importance for the markets,” says an Esma spokesperson. “In particular, we welcome the proposed strengthening of the third-country framework for CCPs.”

The Commission’s proposal, which would amend both the European Market Infrastructure Regulation and the Esma Regulation, has yet to be approved by the European Parliament and Council, and some lawmakers in the powerful Economic and Monetary Affairs Committee have said they would have preferred a harder line, including vice-chair Markus Ferber.

“The Commission has lost its courage when it comes to euro clearing. We do not need a case-by-case analysis, but one clear rule. The rule must be that euro clearing must be done under EU jurisdiction—no ifs or buts,” he says.

The EU may yet face legal challenges on the issue, also. In 2015, the UK successfully argued against a previous attempt to force the clearing of euro-denominated derivatives to take place within the eurozone in the European Court of Justice.

“History has shown that carrots are better than sticks in changing peoples’ behavior. If you really want an industry to move wholesale to a different country then you have to give those people some pretty compelling incentives,” says Fidessa’s Grob. “None of those seem to be in evidence at the moment.”