After more than a decade of hesitation, the EU is now finally moving on to put in place a proper regulatory architecture for clearing and settlement. Following the agreement on EMIR, the EU Commission has proposed harmonized rules for CSD’s, while the European Central Bank (ECB) is moving on with its plans for a central euro-zone settlement entity. After the unfortunate bypass of the 2006 Code of Conduct, the EU will now have rules to ensure cross border provision of services, (interoperability) and competition between clearing and settlement entities in the EU. This will bring sea change in the sector, and could lead to further concentration in the sector to respond to tighter margins, as we have seen in the area of trading platforms.
The move to require central clearing of derivative trades follows the huge uncovered positions in bilateral OTC derivatives trading, mainly with the US group AIG, which lead to the policy actions in the London and Pittsburg G-20 meetings. The Pittsburgh G-20 decided that ‘all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.’1
Together with the reinforcement of bank capital, mandatory central clearing is one of the most important shifts brought about by the financial crisis, on which many questions remain, however. Will CCPs be capable to cope? What is the level of capital for CCPs, what level of margins on collateral? What is the impact on the large operators in derivative markets? What are the consequences for availability of collateral in the global financial system? How can it be avoided to concentrate too much risk? Related to this is the ambition to create centralized repositories for OTC trades. The action on settlement, as well at EU Commission at ECB level, was on the agenda already well before the financial crisis, but the resolve to go for harmonized rules and a single settlement engine was facilitated by the crisis.
The central role of CCPs
CCPs will have a central role in the financial system, although it will only affect a few players seriously. The derivative market on both sides of the Atlantic is dominated by five players, which control about 80% of the market. The cost for a participation in a CCP and the impact on the profitability of the financial sector will thus largely affect these players, but also the eventual reduction in systemic risk is mainly in the hands of the same. The question whether risk is better controlled when multilateralised and internalized in a few CCPs remains. For this to happen, much depends on the eligibility of derivatives for central clearing, which is assumed to be somewhere around 2/3rds of total notional amount, and the governance and control of CCPs.
European Market Infrastructure Regulation (EMIR) remains in its final text very much at the level of principles in the eligibility of derivatives for central clearing and the prudential requirements. But the text has doubled in length as compared to the Commission’s draft, mainly as a result of exemptions from the scope of the regulation (i.e. intra-group transactions) and the clarification of the third country provisions. Moreover, much remains to be done in implementing rules: 40 of the 77 items on ESMA’s 2012 work program concern EMIR.2 This obesity of rules is a trend that can be noticed with other post-crisis financial regulation measures, the question remains what its long term impact will be.
Entities that are exempt from the scope of the regulation are non-financial corporations and pension funds (for a three years transition period). The exemption for non-financial corporations was already on the agenda well before the text was formally proposed, and has been maintained, albeit with the maintenance of a clearing threshold. The same applies in the US under Dodd-Frank, but is only expected to come into effect in the second half of 2013. The exemption for pension funds was a major success of lobbying with the European Parliament, but does not apply in the US.
In formal terms, the clearing threshold for non-financial corporations is not set in EMIR, but will be subject to implementing legislation proposed by European Securities and Markets Authority (ESMA), which will set criteria on which OTC contracts are to be included and the values. In relative terms, it revolves around positions that are not objectively measurable as reducing risks directly related to the commercial or treasury financing activities of the counterparty or of that group (Art. 7.3).
The exemption from central clearing for pension schemes is less clearcut, as it is only applicable during a transition period of three years. Pension schemes successfully made the point that the margin requirements of CCPs would reduce returns for future retirees. But OTC derivatives contracts entered into by pension schemes will be subject to the reporting obligation and bilateral collateralisation requirements. ‘The ultimate aim is, however, central clearing as soon as this is tenable’ (Recital 15). This derogation also applies to group insurance schemes, provided they are ring-fenced from other activities within the insurance group (Recital 15a).
CCPS WILL HAVE A CENTRAL ROLE IN THE FINANCIAL SYSTEM, ALTHOUGH IT WILL ONLY IMPORTANTLY AFFECT A FEW PLAYERS.
EMIR follows a dual approach for the authorization of CCPs. EU-based CCP’s are authorized by the relevant authorities in their home country, whereas authorized 3rd country CCP’s can be recognized to do business in the EU by ESMA, subject to a cooperation agreement with its supervisory authorities.
The basic prudential and business conduct standards for CCP’s today comprise:
- initial capital requirement of EUR 7.5 million (Art. 12)
- exposure management, margining rules, default fund, collateralization and investment policy (Art. 38-46). CCP’s can have access to central bank liquidity and settle in central bank money.
- governance and conduct requirements (segregated client accounts, conflicts of interest, outsourcing, Art. 31-37)
These rules, and above all those under print item (2) are key to the well functioning of CCP’s, but also of the doubts that remain among specialists regarding the resilience of CCP’s. 11 of the 40 EMIR items in ESMA’s regulatory work programme 2012 relate to the substantiation of these prudential rules.
Once the initial conditions have been met, clearing houses will be able to offer their services freely within the EU, after notifying host country authorities. So far, further to MiFID (Art. 34), investment firms could have access to host country clearing and settlement services, but the latter could not provide their services freely across borders, which is what EMIR now permits. CCP’s may enter into interoperability arrangements, provided certain criteria are met, subject to a three year test period (Art. 50).
Once the initial conditions have been met, clearing houses will be able to offer their services freely within the EU, after notifying host country authorities.
A second part of EMIR deals with the registration and operation of trade repositories, these are entities that centrally collect and maintain the records of any derivative contract CCP’s have concluded . Any modification, or termination of the contract is reported to a trade repository.
Trade repositories will be authorized by ESMA, and thereby become, after rating agents, the second specific and unique group it oversees. In return for doing so, ESMA shall charge fees to the repositories, which should fully cover its expenses. ESMA may delegate supervisory tasks to the member states authorities. Trade repositories from third countries may also be recognized as soon as an equivalence agreement with the country in question has been concluded.
To supervise properly means that ESMA needs to have the powers to undertake general investigations, do on-site inspections of and eventually impose fines upon trade repositories. This is, in a European context, new, although it also appears already in the rating agencies regulation.
Data collected by TR should be made available to the relevant European and national supervisory authorities.
With a delay of more than 10 years, the EU will finally have a regulatory framework in place for the back-office.
The CSD proposal
Following EMIR, the single license facilities should also apply to central securities depositaries, which hitherto had only been subject to a self-regulatory Code. While the Code made some progress in the area of price transparency, hard core issues such as interoperability and service unbundling did not advance, as too much was at stake for the operators. The draft regulation requires transparent access criteria, price and fee transparency, interoperability between CSDs and with other infrastructures, such as CSDs. It follows gross modo the same equivalence method as EMIR for third country CSDs access to the EU market.
An article to be followed regards the provision of banking services by CSDs, as some do. The draft CSD proposal states that these entities cannot provide ancillary banking services, although an exception can be made in reasoned request to the EU Commission. As CSDs will have to look downstream to expand their services with the arrival of Target2- Securities (T2S), they will come even more in direct competition with custodian banks. In this context, the current phrasing of the provision may leave too much discretion to the EU Commission, and uncertainty for CSDs.
Finally after more than 10 years, the EU will finally have a regulatory framework in place for the back-office. This will on the clearing side spur huge change, as a new market has to be structured for the central clearing of hitherto bilaterally traded derivative contracts. Huge investments are to be expected in clearing technology, which will bring sea change in the coming years. On the settlement side, free competition between CSDs will lead to further concentration in the sector, as this is a scale business by excellence, but also lead to competition with specialized banks for the expansion of territory. With a growing concentration in the clearing and settlement sector, the task for macro and prudential supervisors will not become easier.
About Karel Lannoo
- Chief executive of the Centre for European Policy Studies (CEPS) since 2000. CEPS is one of the leading independent European think tanks, with a strong reputation in economic and foreign policy research. It budgets total revenues of EUR 9 million for 2012 and employs about 50 persons
- Directs the European Capital Markets Institute (ECMI) and the European Credit Research Institute (ECRI), both separate legal entities that are managed by CEPS
- Regular speaker at hearings of EU, other national and international institutions (OECD, World Bank, ADB) and in executive programmes.
- Published some books and numerous articles in newspapers (FT, WSJ, FD, FT, De Tijd), specialised magazines and journals on general European policy, and specific financial regulation and supervision matters. On MiFID, co-authored The Mifid Revolution with Jean-Pierre Casey, published by Cambridge in September 2009, and MiFID 2.0 with Diego Valiante, published by CEPS in February 2011. On asset management, he published in 2008 with Jean Pierre Casey, UCITS and Asset Management in the EU after MiFID., and in 2012 Rethinking Asset Management with Mirzha Demanuel. Other recent publications and opinion pieces include: The Commission’s CRD IV requires a deeper reading (January 2012); EU federalism in crisis (December 2011); MiFID 2.0 unveiled (November 2011); Lessons from the 2008 crisis for a 2011 Eurotarp (October 2011),Opinion polls support a more European approach to the crisis, (August 2011), The EU’s Response to the Crisis: A Mid-term Review, (April 2011), The forest of Basel III has too many trees, (February 2011)
- independent director of BME (Bolsas Y Mercados Espanoles), the listed company that manages the Spanish securities exchanges
- Karel Lannoo holds an MA in history (1985) from the University of Leuven, Belgium and obtained a postgraduate in European studies (CEE) from the University of Nancy, France (1986)