The Bruxellian Job: Europe Targets London Clearinghouses

Nobody expected Brexit’s initial exchange of fire to take place in a quiet, arcane corner of the financial markets. Yet on June 13, that’s precisely where European authorities launched their first broadside. Their target was London’s powerful clearinghouses, and the impact sent a shockwave of unease through the industry.

That afternoon, during a short press conference in the European Union’s (EU’s) Strasbourg buildings, vice-president Valdis Dombrovskis of the European Commission (EC) outlined proposals for how third-country—European legalese for “non-EU”—central counterparty (CCP) clearinghouses should be supervised. Important CCPs would be subjected to dual supervision between the EU and their home regulators, owing to their importance in the financial system, he said.

But the most important clearinghouses, he continued, faced the possibility of extraordinary measures. “In some specific circumstances, and as a last resort, authorities may require individual CCPs to be established within the EU,” he said, reading from prepared notes.

Traders and risk managers at major dealers were blunt in their assessment. One clearing specialist at a US bank, contacted by Waters for comment as the news broke, was silent for a few moments, before letting out a long breath. “So they actually did it?” the source asked. “Jesus Christ.”

Tech Tangles

The possibility of a clearinghouse having to up sticks and move from London to Paris, Frankfurt or another European financial capital has tremendous technology implications, at least in the short term. Aside from the need to replicate the infrastructure in use at each location, CCPs are responsible for daily activities crucial to the efficient running of derivatives markets on a global scale. “The safety and soundness of CCPs matters for central banks, and it matters a lot,” says Benoît Cœuré, a member of the executive board of the European Central Bank (ECB). “What concerns us today in the context of Brexit is that the current EU regime regarding third-country CCPs was never designed to cope with major systemic CCPs operating from outside the EU. Indeed, this regime relies to a large extent on local supervision, and provides EU authorities with very limited tools for obtaining information and taking action in the event of a crisis.”

But despite these concerns, moving the location of a clearinghouse’s systems, and resetting those connections, would be what the US bank’s clearing specialist describes as a “Herculean” task in the short term, one fraught with the potential for mishap.

Clearinghouses are best known as risk managers within the financial markets, entities that stand between buyers and sellers of derivatives, that guarantee the trade in the event that one party defaults. This is largely accomplished through the collection of collateral, or margin, from counterparties, but the technical clout needed to calculate and distribute margin on such a scale is immense—the largest CCPs handle trades collectively worth trillions of dollars on a daily basis.

Then there are the ancillary services offered by CCPs, which rely heavily on technology to accomplish their tasks. The netting of trades, in which a financial institution’s long and short positions are compared and aggregated so as to arrive at an overall margin call, rather than duplicative individual calls, is performed on a daily basis. So too is compression, where similar trades are reconstituted into single transactions with the same economics.

More recently, CCPs have begun to explore portfolio margining, where a firm’s listed and over-the-counter (OTC) trades are examined for correlations and offsets so as to further reduce margin requirements. Plugging in to all of these processes are third-party systems, such as collateral management platforms and inventory management systems, not to mention reporting software and trade ledgers.

A Delicate Balance

All of this exists in a fine balance, where systems are subjected to rigorous standards and uptime guarantees. Moving that infrastructure seamlessly is possible, but it would be no mean feat, says Steve Grob, director of group strategy at technology vendor Fidessa.

“It seems pretty clear to me and a whole bunch of other people that the concept of relocating clearing was a great thing to say, and a great thing to get lathered up about in a Brexit context, but is actually pretty meaningless because you can’t just pick something physically up and move it,” Grob says. “It’s like saying ‘I’m going to pick up Silicon Valley and put it in Detroit.’ Easy words, but what does that actually mean?”

Then there are further challenges that relate back to technology, but stem from more prosaic concerns, such as which legal jurisdictions the CCP’s contracts fall under once it has moved. Indeed, there are questions over whether moving a clearinghouse is even a practical exercise, or just political posturing. “Truth be told, one of the reasons people do their euro clearing in London is that they like the way it’s set up,” says Grob. “They want contracts in English, they want things subject to UK law, and they feel that it’s the safest place to do it—otherwise they just wouldn’t. So the idea that you can pick it up and change it, unless you can offer some massive carrot to participants, was always going to be a problem.”

The proposals represent a sea change in how the EU interacts with foreign nations from a regulatory perspective. Up until this point, Europe had used a system of “equivalence” to assess supervisory compatibility for CCPs, a determination that a foreign host-country’s legal and regulatory system was at least as strong as that which is currently in place within the EU, says Roger Storm, head of clearing services at Zurich, Switzerland-headquartered SIX Group.

“The system of mutual recognition of third-country legal regimes and oversight functioning has worked well for many years, and I haven’t heard arguments why this could not continue to be used. I hope common sense and pragmatism will prevail,” he says.

New Landscape

European incumbents would likely be the prime beneficiaries of the proposals, not least of all Deutsche Börse-owned Eurex Clearing, which has long competed with ICE and LCH’s UK clearinghouses. “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,” says Erik Müller, CEO of Eurex Clearing. “Eurex Clearing fulfils all CCP rules defined by the European Market Infrastructure Regulation, as well as relevant EU banking rules, in light of Eurex Clearing’s full banking license for secured and permanent access to the ECB.”

In a broad sense, most market participants agree that the operational challenges involved with relocating a CCP are problematic at best, and at worst, introduce the possibility of creating systemic instability—the very consequence that the proposals are meant to avoid.

“Fragmentation is in no one’s economic interest,” said BoE governor Mark Carney, in his annual Mansion House speech on June 20. “Nor is it necessary for financial stability. Indeed it can damage it. Fragmenting clearing would lead to smaller liquidity pools in CCPs, reducing the ability to diversify risks and diminishing resilience.”

The clearinghouse LCH, majority owned by the London Stock Exchange Group (LSEG), is also a proponent of this belief. “Regulatory cooperation, which the UK currently enjoys with the US, supports financial stability across the entire market, as well as providing very substantial economic efficiencies for customers, and hence for the real economy as well,” says a spokesperson for the LSE. “A location policy does the opposite—it increases, not decreases, risk and costs for customers.”

Officials at the LSE point out that LCH already has a European presence through its LCH.Clearnet SA CCP, based in Paris, which handles clearing for listed and credit derivatives, as well as its ownership of Italian clearing house CC&G. But the proposals could also affect CCPs such as ICE Clear Europe, a London-based CCP dominant in credit and energy derivatives clearing. “The devil is in the detail, and we don’t have that as yet,” says an ICE spokesperson, declining to comment further.

LCH, which did not answer specific questions from Waters on how it would handle any relocation, has an extraordinary amount of skin in the game. Based in London, its SwapClear service handles over 90 percent of the cleared interest-rate swaps market, with contract lengths as long as 50 years in duration. It also clears the bulk of swaps denominated in euros, a fact that made European supervisors uneasy long before the UK voted to leave the European Union in June 2016.

Indeed, the wider EU has long envied London’s pre-eminent position in financial markets, and coveted its dominance in clearing. In 2015, the UK successfully fought off a bid by the European Central Bank (ECB) to force CCPs that cleared euro-denominated instruments to relocate to the Eurozone, and thus under its purview. The European Court of Justice had ruled that the ECB lacked the authority to oversee such businesses. But it would eventually be a small regulator with a bureaucratic-sounding name—the European Securities and Markets Authority, or Esma—that would prove to be the key to Europe’s second stab at repatriating euro clearing to the continent.

Unreliable Narrators

While it’s true that equivalence has mostly worked well, those with knowledge of the EU’s thinking say that Brexit has created stark uncertainty within the halls of power. “On the one hand, you have the UK as we’ve historically known it—financially literate, competent in supervision and solidly reliable,” says a Brussels-based lobbyist. “But then you have Brexit, you have talk of grand repeal bills, and looking ahead, potential divergence from the EU. That’s not a comfortable position to be in, and agencies like Esma have been quite adept at dropping hints here and there that maybe it would be better if everything were kept in the family, so to speak.”

Esma is not widely known outside of financial circles. The pan-European regulator is perpetually underfunded and thinly staffed—its budget of just over €40 million ($45 million) for 2017 and its 150-strong headcount is dwarfed by many of the national regulators that it is supposed to oversee—but it packs an outsize punch, having written the bulk of the technical standards for most major pieces of European regulation after the financial crisis.

Since 2012, it has also directly overseen European clearinghouses, giving it the supervisory competencies the ECB lacked, and which cost it the initial court battle over CCP location policies. With the EC’s proposal, Esma’s powers will be extended further, with new responsibilities for ensuring CCPs don’t collapse, and, critically, the ability to make a recommendation to the EC that a systemically-important CCP should be forced to move to the eurozone. The criteria under which Esma assesses the systemic importance of a CCP should be defined in further legislative acts, the proposal states. Once such a determination is made and accepted, the EC states, clearinghouses would have 12 to 18 months to move their operations.

The proposals mark a culmination of months of campaigning on Esma chief Steven Maijoor’s part. The chairman of the regulator has frequently mentioned the fact that Esma does not consider current third-country arrangements to be sufficient for CCP oversight in speeches and in Parliamentary hearings since the UK voted to leave the EU, both indirectly and with specific reference to Brexit.

An Esma spokesperson says that the regulator welcomes “the proposed strengthening of the third-country framework for CCPs,” but that it is still studying the specific proposals put forward by the EC, and does not have further comment at this stage. However, the spokesperson adds that, in a general sense, Maijoor has said in the past that any new tasks for the regulator should include proposals for specific funding. The EC proposal mentions that the new responsibilities could be paid for primarily by supervisory fees extracted from CCPs, but does not promise additional EU funding.

It is unclear how Esma would manage these tasks without further resources. The regulator has been so cash-strapped in the past that it has had to cut back on internal technology projects, staff travel and even stationery costs in order to prioritize its major tasks, such as a centralized reference data utility, enhanced data and risk analytics technologies, or rulemaking requirements for incoming regulations.

Cost Control

The proposal still has to be adopted and approved by both the European Parliament and Council under EU rules, but might still face some opposition—for not being harder on London. “It is inconceivable that supervision of euro clearing is done by a third-country authority, but the eurozone would be asked to step in with emergency liquidity assistance during a crisis. That would create the kind of moral hazard we always wanted to avoid,” says Markus Ferber, a German Member of the European Parliament who sits on the powerful Economic and Monetary Affairs Committee. Ferber criticizes the EC proposal as being too lenient, and for creating uncertainty by determining CCP status on a “case-by-case basis” rather than through “one clear rule.”

“The Commission has lost its courage when it comes to euro clearing,” he says.

Although the EU insists that these powers will only be used as a “last resort,” the mere possibility of a forced relocation has been enough to unsettle market observers, leading to broader concerns about how other key battlegrounds in Brexit will emerge in the years to come. For now, however, institutions that have become the nervous system of markets since 2008 have been placed squarely in the crosshairs.

“It is too early to say how this all will play out,” says SIX Group’s Storm. “But the swords seem to have been drawn between the EU and the UK regarding control, oversight and domiciliation of these central financial-market risk management entities.”