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EU Financial Services Commissioner Mairead McGuinness speaking at an insurance regulation event in Brussels, Sept. 22, 2021.The clearing industry wants the European Union to let U.K. clearing houses continue serving EU customers for far longer than the existing allowance.
British clearing houses, despite no longer being in the bloc following Brexit, are allowed to serve EU customers until June 30, 2022. The U.K., led by LCH Group Holdings Ltd.'s SwapClear arm, clears the bulk of interest rate derivatives — financial instruments designed to protect against changes to interest rates — in Europe, with an 82% share of notional, or the underlying amount an investor has contracted to buy and sell, in 2019, according to the EU's securities regulator.
Clearing plays an important part in finance, with clearing houses serving as an intermediary between two trading partners and collecting collateral from each side. The EU wishes to bring more of this business into its scope, partly due to concerns tied to the eurozone debt crisis of 2011-2012. At that time LCH's U.K. operation raised the margin on sovereign debt clearing for Spain, Ireland and Portugal, which added to concerns
EU Financial Services Commissioner Mairead McGuinness said Nov. 10 that the bloc will extend the equivalence period, whereby it recognizes post-Brexit Britain's regulations around clearing trades as equivalent to its own, after the current 18-month extension runs out. The EU intended to build up its own clearing capacity over that time, but McGuinness said it has not happened fast enough.
A call for longer-term fixes
Details are expected in the new year but the EU has not indicated how long a new extension may last. Some in the industry expect an initial extension of one year with the possibility of additional time thereafter, according to Kirston Winters, chief risk officer at post-trade service company Osttra. But a longer extension period of perhaps four or five years, together with incentives for firms to shift clearing capacity into the EU, would make more sense, Winters said. Without incentives, market participants would likely not shift additional capacity to the bloc, he said.
"If the EU said European firms must do certain things by certain dates to gradually push more liquidity and some additional clearing capacity into the EU, then I think the European Commission could consider that as a move towards strategic autonomy," Winters said. Osttra is jointly owned by IHS Markit Ltd. and CME Group Inc.
The Futures Industry Association, which represents clearing firms, said short-term fixes were damaging.
"Everyone wants there to be a longer-term solution because the current system of having a time-limited exemption creates unnecessary uncertainty," said Futures Industry Association board member Michael Voisin.
Frankfurt-based Eurex Frankfurt AG's market share for outstanding notional euro-denominated interest rate swaps increased at a rate of around 0.5% a month over the past year, while U.K.-based LCH Group Holdings Ltd.'s share had decreased by a similar amount. LCH's Swapclear arm accounted for 83.5% of this market on Aug. 1, compared with 15.3% for Eurex.
European clearing houses' share of the cleared euro-denominated swaps market fell back slightly in August and September, based on Osttra data, said Winters. Many market participants regarded this as an indication that the EU would be highly likely to grant a further temporary extension to equivalence for clearing.
LCH said it was pleased the EU had offered an extension, and that alone brought some stability to the market, which was its key concern.
"We would always look to the regulators to allow certainty into the market to ensure stability. I think everybody recognizes that you don't want the uncertainty of the past couple of years again," said Lucie Holloway, head of financial and corporate communications at London Stock Exchange Group PLC, which owns LCH.
Shifting regulatory landscape
The U.K.'s exit from the EU has changed the risk picture since British clearing houses are no longer covered by EU law in relation to recovery or resolution, according to the European Banking Authority, the EU's bank regulator. Brexit has increased the bloc's dependence on the regulatory framework of the U.K.
However, eurozone sovereign debt is now cleared by LCH in Paris, alongside related business in repurchase, or repo, markets, having moved there from the U.K. prior to Brexit. This means such transactions fall under EU supervision and would be shielded from any potential future regulatory divergence from the U.K.
Shifts in clearing locations should not be mandated by regulators since this risks driving up costs, according to representatives of the industry.
"The clients should determine where the derivatives are cleared," said the Futures Industry Association's Voisin. "In a free market that should be a free choice; there should not be a regulatory direction one way or another."
The EU caused a stir earlier this year when it asked EU banks to outline how they might shift all euro-denominated clearing activities to within the bloc. Bank of England Governor Andrew Bailey said the move was of "dubious legality."
The EU's aim of building up its own clearing operations is to curb the bloc's overreliance on third-country clearing houses and safeguard financial stability in the medium term, an EU spokesperson told S&P Global Market Intelligence. The spokesperson declined to comment on the timing of an extension to equivalence.
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