Versions of this article were first published in the May issue of Butterworths Journal of International Banking and Financial Law ((2021) 5 JIBFL 364) and in the Financial News online edition, Issue 1232, p.19
Of all the controversies of Brexit, one of the most vexed is the impact on OTC derivative clearing. In particular, whether Europe's clearing market structure requires what is colloquially known as a "location policy". Recently various media have reported that Europe’s top banks have been asked by the European Commission to justify why they should not shift clearing of euro-denominated derivatives from London to the EU. This appears to have prompted Andrew Bailey, Governor of the Bank of England, to make a statement to the Treasury Select Committee at the end of February setting out the Bank's position in no uncertain terms. EU attempts to encourage clearing of euro-denominated derivatives to migrate to the EU, the Governor observed, would be "highly controversial" and something that the Bank would "resist very firmly".
This debate is not, of course, new. As Andrew Bailey noted, location policy first surfaced as a topic in 1999 at the birth of the Eurozone. It has received renewed focus in the years following the Brexit referendum and due to the growth of the cleared euro-denominated OTC derivatives market. An overwhelming majority of this market, having a value of approximately €83.5 trillion, is currently cleared by LCH Limited in London. The question on people's minds following Brexit is whether so much of the euro-denominated derivatives market should continue to be cleared outside of the EU.
Currently, LCH Limited is recognised as a third country CCP under the European Market Infrastructure Regulation ("EMIR") on the basis of a temporary equivalence decision by the European Commission which remains in force until 30 June 2022. In a sense, we are at a crossroads and EU decisions taken in the next 13 months on location policy could significantly alter the European clearing landscape.
In his statement to the Treasury Select Committee, the Governor succinctly summarised the arguments against a location policy. He noted the netting efficiencies and reduced costs of concentrating a large pool of cleared contracts in a single CCP, with attendant financial stability benefits. Fragmenting clearing, he said, would dilute these benefits, eroding the stability of the global clearing system.
On the face of it, these arguments appear compelling. So what are the arguments in favour of a location policy for clearing euro-denominated derivatives? Perhaps the key one is the legitimate interest of the European Central Bank, as a central bank of issue, to be in a position to fulfil its monetary policy objectives. These include ensuring the smooth operation of European payment systems, maintaining Eurosystem price stability and having the flexibility to respond appropriately to a CCP crisis. Here a delicate balance must be struck with non-EU CCP supervisors who are concerned with financial stability. The ECB's area of competence borders and relates to supervisory interests. Co-operation and information sharing together with an appropriate level of consultation would seem to be essential.
To encourage this, in 2020 the EU regulatory package known as "EMIR 2.2" created a mechanism for the European Commission to implement a location policy with respect to clearing services of non-EU CCPs of substantial systemic importance (defined as "Tier 2 CCPs"). The location policy is expressed in the legislation to be a last resort if financial stability risks cannot otherwise be sufficiently addressed. The European Securities and Markets Authority has designated LCH Limited as a Tier 2 CCP.
Some commentators have also questioned the assertion that costs and netting will be negatively impacted by a location policy. Depending on the assumptions made, some modelling suggests that if CCPs which meet international standards are appropriately linked, the multilateral netting benefit may actually be increased and overall costs may be decreased. From a system-wide perspective benefits may outweigh systemic risks. If the EU was to invoke a location policy for euro-denominated clearing this would disrupt the status quo and be a powerful catalyst for the emergence of new clearing market structures. This might include a greater focus on the development of interoperability and other peer-to-peer links such as cross-margining, with improved market integration and CCP access for end users. Despite the tremendous development of OTC derivative clearing in the past decade, the law and practice surrounding links between CCPs clearing OTC derivatives remains in its infancy. EMIR is largely silent on this area, as is the new CCP Recovery and Resolution Regulation.
Other arguments in favour of a location policy have also been advanced. The near monopoly which LCH Limited currently has on clearing euro-denominated derivatives has been questioned on competition grounds. Finally, it is possible that political considerations may also play into the location policy debate.
It is safe to say that whatever the EU decides in the next 13 months on euro-denominated derivatives clearing and approach to the UK's Tier 2 CCPs, there will be far reaching implications for the evolution of the global derivatives clearing system.