The European Commission’s latest derivatives clearing proposals omit crucial details that will ultimately determine how damaging the reforms could be for European banks and other swap users, industry experts say.
The Commission on Wednesday announced a series of measures aimed at bringing more clearing of interest rate and credit derivatives within its borders – one of the most important financial initiatives European policymakers have pursued since Britain’s Brexit vote. These will require EU-based firms to route an unspecified portion of certain euro derivatives (and some denominated in Polish zloty) through so-called active accounts with EU-based CCPs.
But the Commission has delegated the details of how much activity needs to be relocated within the EU to the European Securities and Markets Authority, leaving a number of important questions unanswered. These include whether EU authorities will grant carve-outs that local banks are pushing to ensure their derivatives operations are not cut off from some parts of the financial markets after the reforms.
Bill Stenning, Head of Public Affairs UK at Societe Generale, said the proposals had been “fairly well received” but noted there were concerns.
“The concerns lie in … the lack of detail, particularly whether market making and client clearing are in or out of scope. Much of the euro swap trading takes place with offshore clients. To be competitive onshore you need access to the entire market. If you’re restricted in what you do, it can be difficult to compete with other companies that aren’t,” he said.
“We are committed to ensuring that these criteria are properly calibrated,” he said.
battlefield
Derivatives clearing – where trades are routed through CCPs to reduce systemic risk in those markets – has become a key battleground in the EU-UK tug-of-war over the location of certain financial services following the 2016 Brexit vote. The UK’s LCH clears over 90% of the cleared interest rate derivatives market, including the vast majority of euro swap clearing – a fact that has long irritated EU politicians (IFR is part of LSEG, which also owns LCH).
Swap users tended to focus their activities on a specific product in a central counterparty after the 2007/08 crisis pushed for central clearing as increased liquidity and economies of scale have contributed to lower costs. This dynamic has complicated the EU’s attempt to force more clearing into the bloc. The Commission has extended regulatory relaxations for EU firms to clearing in the UK until mid-2025, but still expects EU firms to move more euro-swap activities to shore.
“Some clearing of euro interest rate derivatives has moved to the EU since Brexit, but it has been at a fairly leisurely pace and appears to have plateaued recently. Ultimately, it would help make the EU a more attractive and efficient place for derivatives clearing to drive that process forward,” said Kirston Winters, chief risk officer at post-trade firm Osttra.
Big order
The Intercontinental Exchange’s decision to close its London CCP for credit default swaps could help the EU cause. LCH operates a Paris-based clearinghouse for CDS, which could attract companies not migrating to ICE’s US-based clearing offering. Industry insiders have also been hailed by Commission proposals to boost the competitiveness of clearing in the EU.
But the EU still faces several challenges in poaching more activity from London in interest rate derivatives. The most important of these is that a large part of the clearing of euro interest rate derivatives does not involve EU firms (up to three quarters of the market, according to LCH).
Many global companies will clear euro swaps alongside US dollars, sterling and other currencies, making them more efficient when trading in one place. Frankfurt-based Eurex Clearing, the main clearing house for EU interest rates, offers far fewer currencies than LCH and the vast majority of its business is focused on euros. EU banks fear a blunt ban on access to LCH could cut them off from a large chunk of the market that has yet to vacate there.
SG’s Stenning said that excluding client clearing from every mandate would be an obvious move. “It is the customer who chooses the CCP. If we have to restrict our non-EU customers, we’ll just lose them,” he said.
split risk
More broadly, industry insiders say the EU must consider the risks of partitioning the euro-swap market in a way that hurts EU-based banks – something that came after it banned EU firms last year, certain to trade derivatives on UK trading venues . The EU’s share of on-venue euro swap trading rose significantly following the move, according to Osttra, but US trading venues were even bigger beneficiaries as the first quarter ended. Furthermore, 15% of this activity still remained in the UK – out of reach of EU banks.
Stenning warned of policies that could result in the market for euro swaps being split between a purely European onshore market and a non-European offshore market.
“Is it really progress to have significant liquidity pools in euros where EU firms are not active? I’m not sure if that’s a desirable result,” he said.
How significant this will be for EU banks thus depends on how the EU authorities shape the reforms.
“The key will be what counts as a material amount and what activities are exempt,” Winters said. “Depending on how it’s calibrated, it could be a big problem [for EU banks] or no problem. As always, the devil is in the details.”
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