21 August 2017

ISDA: Brexit – CCP location and legal uncertainty

Central clearing volumes have increased significantly since the Group-of-20 (G-20) nations identified the clearing of standardized derivatives as a key commitment following the financial crisis. More than 70% of total interest rate derivatives notional outstanding is now cleared, compared with less than 20% prior to the crisis.

This shift is not solely due to clearing mandates put in place by regulators in the US, Europe, Japan and elsewhere. Dealers have embraced clearing as a means to manage counterparty risk, and because of the economic and operational efficiencies it provides.

Those benefits depend on economies of scale, which arise from the ability of globally active firms to clear contracts on a cross-border basis. The greater the participation at a CCP, the greater the potential to realize offsets and reduce margin requirements. The ability to net all exposures to one CCP from instruments in the same asset class – known as multilateral netting – is risk reducing and cost-efficient for clearing members and clients.

It is not clear that global liquidity in euro-denominated cleared contracts would flow to an EU CCP in the event of a location policy. According to LCH, only 25% of its euro-denominated activity is cleared by EU firms. As a location policy can only be enforced on transactions where at least one counterparty is located in the EU, it is to be expected that the clearing pool in the eurozone will be less liquid compared to the current globally integrated pool. Less liquidity will lead to less competition and less choice, and potentially wider bid/ask spreads.

The impact of a basis between a non-EU and EU CCP will not only be felt by clearing members. The net effect of these factors will be most keenly felt by clients, with consequences for financial and corporate investment and hedging decisions.

The EU has implemented the 2009 G-20 commitments on derivatives reform, including a commitment to avoid “fragmentation of markets, protectionism, and regulatory arbitrage”. This approach is reflected in the EU’s advocacy in favor of the principles of deference and international comity in international forums – for instance, IOSCO and the Financial Stability Board (FSB). These principles have been made explicit in successive FSB progress reports on the implementation of OTC derivatives reforms.

An EU CCP location policy would run contrary to the deference principle, and would fragment markets. Fragmentation is harmful to the wider economy, as well as to financial markets. ISDA believes it is appropriate for EU and non-EU regulators to agree arrangements ensuring that EU regulators have adequate oversight of risk managed at third-country CCPs that are relevant to the EU financial system. A CCP location policy would be damaging to EU economic interests, and should not be pursued.

ISDA believes an EU CCP location policy would increase costs for market participants and create a more fragmented and less secure clearing house landscape.

ISDA also urges UK and EU policy-makers to remove any legal uncertainty over cross-border English law contracts by designing transitional arrangements to be put in place after the UK leaves the EU until a proper system of mutual recognition is introduced.

Full paper

© ISDA - International Swaps and Derivatives Association