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After more than a decade of indecision, the EU is finally now set to implement a consistent regulatory architecture for clearing and settlement. Following the agreement on a European market infrastructure Regulation (EMIR), the European Commission has proposed harmonised rules for centralised settlement depositaries (CSDs), while the European Central Bank is moving forward with its plans for a central eurozone settlement engine.
The paper also discusses the impact of the new rules, and argues that, analogous to the unexpected impact of MiFID on trading infrastructures, a similar EMIR revolution may be on its way. The move to require central clearing of derivatives trading is a response to major failures on noncollateralised positions in bilateral OTC (over-the counter) derivatives trading, mainly with the US group AIG, which sparked systemic disruption across the globe and led to a costly bailout by US taxpayers in 2008. The need to put in place effective safeguards to deal with counterparty risk in derivatives trading was a key element of the London and Pittsburgh G20 meetings.
Together with the reinforcement of bank capital, mandatory central clearing of OTC derivatives is one of the most important shifts brought about by the financial crisis, although many questions yet remain about their impact. The capacity of the infrastructure to clear millions of transactions and to facilitate collateral and counterparty risk management in order to minimise adverse effects on credit availability is only part of the challenge. It may also be necessary for competition authorities to more deeply scrutinise the effects on market structure, due to the unavoidable consolidation process to reach critical mass. In addition, there is the objective to create centralised repositories for all OTC derivatives trades. Initiatives in the settlement arena, by both the European Commission and the ECB, were already on the agenda well before the financial crisis hit, but the resolve to go for harmonised rules and a single settlement engine crystallised as a result.
The EU is finally going to have a regulatory framework in place for the post-trade financial market infrastructure. In the context of the financial crisis, this regulatory framework follows two important trends. On the one hand, there is the general mandate given by the G20 to regulators to strengthen financial stability, mainly through transparency and mandatory use of highly standardised infrastructures. On the other hand, since the launch of the Financial Services Action Plan in 1999, Europe has been trying to build a pan-European infrastructure leveraging on healthy competition among national incumbent infrastructures and new pan-European competitors.
Competition is what indeed has kept the single market so far together and given it shape. Europe should continue to work to ensure stability without compromising the higher-level goal of greater integration through competition at pan- European level, and common market architecture with common minimum standards through more effective on-going supervision and enforcement. Any attempt by market operators to impede competition along the long value chain of financial market infrastructure on unfounded grounds of risks for financial stability should be considered as an attack on the single market. It cannot be denied, however, that profitability will go down drastically for the business model of market infrastructures. Due to fiercer competition, revenues may go down even further; therefore, in order to remain commercially viable, they need to integrate their businesses vertically (greater consolidation among trading, clearing and settlement providers is already part of the process) and horizontally to create economies of scale (size) and scope (services).
EMIR, in particular on the clearing side, may instigate a sea change, since a new market has to be structured for central clearing of previously bilaterally-traded derivative contracts. Huge investments have been made and are still to come in clearing technology and value-added services, which will bring important changes in the coming years. Existing CCPs will see huge opportunities for growth, and new ones can be expected to emerge.
On the settlement side, free competition between CSDs may lead to further concentration and vertical consolidation within the sector, as this is a scale business by excellence, but also to greater competition with specialised banks for the expansion of territory. With growing concentration in the clearing and settlement sector, the task for macro and prudential supervisors will not become easier. However, as long as the regulatory and supervisory frameworks ensure that these integrated infrastructures are sufficiently interoperable, i.e. open at each key juncture of their value chain (trading, clearing and settlement), the process of ‘pan-Europeanisation’ of the market infrastructure will continue and be beneficial for financial integration. Locking-in collateral and customers in vertical and non-interoperable market infrastructures may also have spill-over effects on trading flows, by distorting flows from non-vertically integrated infrastructures.
In the short term, this may generate predatory practices by vertically integrated and non-interoperable market infrastructures to push infrastructures that are unable to ring-fence collateral pools with post-trading operations out of the market. This may drive further consolidation but with limited benefits in terms of efficiency, as these pools of collateral will be unable (and unwilling) to interact.
A problem on the supervisory side is the multiplicity of actors: on the European level alone, three different bodies are in charge – the ECB (and other central banks), ESMA and EBA – with licensing and supervision still in the hands of local authorities, contrary to the initial plan. With the banking union project firmly under construction, a more streamlined structure will be necessary, given also that it concerns only a few players of systemic importance. In addition, close cooperation between the two major European supervisors, the ECB and the Bank of England, will be required, in the form of an MoU to structure control. Finally, more light should be shed on the implications of forthcoming market infrastructure regulation on the availability of collateral (total volumes), in particular on the possibility for this collateral and assets, if segregated in individual client accounts by CCPs and for settlement and custody by CSDs, to be re-used for other purposes (re-hypothecation) or to limit its re-use by the infrastructure/intermediary. Based on ECMI's conservative estimates, the securities lending and repo markets in Europe have exceeded more than €6 trillion.
In the end, much will also depend on how each CCP will draft the ‘right of use’ procedures in the se of collateral, in line with the guidelines set by Art. 47 on the investment policy of a CCP (and Art. 52.1 on risk management procedures with interoperability agreements). The entire financial system depends on the integrity and turnover of collateral channels, on which the market has leveraged and grown so rapidly in the last decade. Any change with the potential to generate indirect effects on the architecture of the financial system should be subject to an in-depth investigation and testing period to assess unintended effects and new sources of systemic risk.