On 12 November, FIA held its Compliance and Regulation Forum for members in London where the prevailing theme was the future of cross-border market regulation.
The forum's panel discussion took place the same day FIA, along with 13 other trade associations, sent a letter to the European Commission calling for an urgent extension to the temporary equivalence determination for UK central counterparties, which expires on 30 March 2020.
The trade associations said that without this extension, clearing members in the European Union would not be able to continue as direct members of UK CCPs in the event of a no-deal Brexit, and EU counterparties would not be able to clear derivatives subject to the clearing obligation on those CCPs.
FIA has since welcomed a statement from Valdis Dombrovskis, vice-president of the European Commission, made on 15 November that the Commission intends to extend temporary equivalence for UK CCPs beyond the end of March 2020 expiry date.
In his opening remarks, Bruce Savage, FIA's head of Europe, said, "The UK’s impending departure from the European Union and the introduction of a new European equivalence regime for third country CCPs is changing the nature of cross-border market regulation, with strains developing between the EU, UK and the US, resulting in uncertainty for market participants and market infrastructure providers."
This set the scene for the panel discussion, which considered the immediate cross-border issues that firms in the EU and the UK are facing and the implications for market infrastructure and trading firms over the next few months, with panellists also providing longer-term views on equivalence and the implications for UK and EU markets.
Speaking about the 31 January Brexit extension, Farida El-Gammal, executive director, derivatives clearing regulatory change at JP Morgan, noted that although an immediate cliff-edge scenario has been averted, the prospect of a cliff edge is "still on the table".
"Even if the UK has an orderly withdrawal with an agreement, the transition period is fixed to December 2020, which means the continued delay eats into that time. While there is the option of extending the transition by up to two years, that decision must be made by July next year and is an entirely political decision, not a technical one. Ultimately, cliff edge scenarios that focus on financial market infrastructure – trading venues and CCPs – have not been taken off the table," El-Gammal said.
Carolyn Van den Daelen, head of regulation and compliance at ICE Clear Europe, noted that both legal and Brexit uncertainty among market participants was reaching a "deafening point".
"The whole purpose of the European Market Infrastructure Regulation is to control and manage systemic risks in the EU, and what we're seeing right now is risk increasing. CCPs in the UK have until 30 March for their temporary recognition under EMIR to be extended, otherwise we will have to terminate member agreements, which will ultimately lead to market fragmentation, a decrease in liquidity and the potential cutting off of access to vital UK markets," Van den Daelen said.
"Terminating membership is not something that we want to do, but with the way the rules are written it becomes illegal for UK CCPs to offer their services into Europe. In certain member states, such as Germany, we would become criminally liable," she added.
All the panellists agreed that the impact of a cliff edge scenario would be worse for EU27 firms. "It is our EU-based clients facing the most uncertainty because they don't know whether in six months' time they are going to be able to meet their mandatory clearing obligations at a UK-based CCP, whether they can continue trading on UK-based venues or whether they have to move their trading over to an EU-based venue," said El-Gammal.
Katy Hyams, head of regulatory policy at London Metal Exchange, agreed, saying: "The risks on the EU-side are very material. While for UK CCPs, there could be a limited loss of volume and potentially a limited loss of revenue, it's not something that we could not manage, compared to EU members who would have to try and find somewhere where they can clear."
As an example, she said LME has metal contracts that provide a global price, allowing clients to hedge effectively. "The irony is that a lot of trades for EU participants may have to go into OTC if we couldn't get equivalence or recognition, which would not give clients the same hedge that they would get on an exchange. The risk remains; the cliff edge remains. Market participants are optimistic about there being a solution, but until it's published, we cannot be relaxed about how we manage this."
Savage discussed the consequences for EU27 firms in the event of a loss of equivalence for UK CCPs and trading venues. "There would be potentially serious commercial consequences for EU 27 firms if UK CCPs terminated memberships. For instance, EU sell-side and buy-side firms would no longer be able to access deep pools of IRS liquidity on LCH subject to the clearing obligation, and firms would be unable to access certain commodity and metals contracts which are only available on UK exchanges," Savage said.
"There would also be a punitive increase in capital due to UK CCPs becoming non-qualified, and a significant increase in margin and other costs due to a loss of cross currency netting. In addition, there would be level playing field concerns as a result of international clients still being able to access UK CCP via non-EU service providers, and significant operational challenges and risks on closing and reopening trillions of euros of positions in a short period of time at high market cost," he continued.
At the same time, costs are also being incurred by UK firms to ensure contingency plans are in place to access EU clients and venues, Savage said.
"There's uncertainty around the temporary permission regimes and exemptions in some EU jurisdictions and whether firms will be able to access markets from the UK to provide DEA services or trade for own account, which potentially harms liquidity on EU venues," Savage said. "Contingency plans have largely been put in place, but setting up new authorised entities and memberships in Europe together with the operational infrastructure and efforts to migrate contractual arrangements to continue to access the markets and clients is a costly process."
Another topic under discussion was EMIR 2.2 tiering and comparable compliance. On 11 November, ESMA published three sets of technical advice regarding third-country CCPs under the revised EMIR 2.2 regime.
This came after FIA, ISDA and AFME submitted a response to ESMA’s Level 2 consultation on tiering and comparable compliance, making key recommendations and highlighting members' concerns that ESMA's proposed indicators that would assist with the determination of whether a third-country CPP is systemically important were too broad and precluded legal certainty. On comparable compliance the associations said they supported an outcomes focused approach for ESMA’s comparability analysis, rather than a strict line-by-line approach.
Van den Daelen described the tiering proposal as "vague and somewhat subjective" and agreed that an outcomes-focused approach was preferable. "When you look at comparable compliance, ESMA's draft advice is really a line-by-line review of whether a CCP's home legislation looks like EMIR. This line-by-line comparison is quite dangerous, and it could force CCPs to examine whether they want to be a tier two CCP and whether the cost outweighs the benefits of serving those customers," she said.
The European Commission is presently developing the technical advice into corresponding Delegated Acts, on which it will consult publicly before finalising them.
"The EC has been very complimentary regarding the FIA response and we are expecting them to include four quantitative thresholds to allow a CCP to determine tiering with a high level of confidence," said Savage, adding that the Level 2 text will likely be finalised, at the latest, by the middle of next year, which would then give ESMA 18 months to review all jurisdictions by the end of 2021.
"If the process for providing data to ESMA is too onerous for small CCPs, we could see smaller CCPs around the world dropping out and not being equivalent," he warned.
For El-Gammal, EMIR 2.2, as it stands, leaves too much discretion with ESMA and opens the process for political forces to potentially come into play. "I think the concept of having some type of quantitative threshold is important," she said.