The chief executive of the UK Financial Conduct Authority, Andrew Bailey, has said the European Union needs to extend temporary permission for UK clearing houses beyond its planned expiry date of March 30, 2020, to prevent EU clearing members being denied access.
In December 2018, the European Commission adopted an act allowing EU clearing members to temporarily access UK central counterparties for a 12-month period, starting from the original Brexit date of March 2019, in the case of the UK leaving the bloc without a deal.
Although the UK and EU have agreed twice to delay the UK’s exit from the bloc, now scheduled for October 31, the temporary equivalence measures will still lapse on March 30, 2020.Meanwhile, EU CCPs will be granted temporary permission from the Bank of England for a period of three years, starting from the moment the UK leaves the bloc.
The European Commission’s (EC) vice-president for financial services has said in a recent interview with the Financial Times that firms should prepare for the March 2020 date. But Bailey argued there is a need for the EU to extend temporary equivalence further to ensure there is no disruption.
“The EU authorities have mitigated material disruption to cleared derivatives markets by announcing temporary recognition and conditional equivalence decisions for the UK CCPs, and the regulatory framework for them,” said Bailey, speaking in London on September 16. “Though I should make clear that, with the elapsing of time, there will soon need to be agreement to renew this arrangement.”
Without greater clarity on the regulatory status of UK CCPs, the contracts that EU members clear with UK CCPs will need to be closed or transferred
Andrew Bailey, UK Financial Conduct Authority
If the EC does not extend temporary equivalence or grant it permanently to UK CCPs, the likes of LCH and LME will have to serve their EU clearing members with three-month cancellation notices, telling the firms they will be off-boarded from their service. The latest this can happen is December 29. Those clearing members would then have to undertake the mammoth task of closing out or transferring trillions of pounds worth of derivatives contracts from those CCPs to EU-authorised ones.
“Without greater clarity on the regulatory status of UK CCPs, the contracts that EU members clear with UK CCPs will need to be closed or transferred by them,” said Bailey. “So this process would need to be done by the end of this year, but it imposes significant costs on EU firms, as well as straining market capacity. Further action could therefore be necessary to prevent this. I also think the best solution is for the EU to grant permanent recognition of UK CCPs.”
Primacy of politics
Bailey’s speech was part of a broader pitch for the EU to make greater use of temporary equivalence measures and even to grant permanent equivalence decisions to the UK’s financial sector.
“We took the view that there should be wider use of temporary permission than is already the case – and [for] clearing… it needs to be extended,” he said.
On the sidelines of Bailey’s speech, a UK-based lawyer tells Central Banking sister title Risk.net that it would legally make sense for the EU to grant the UK equivalence, because the UK’s rulebook for clearing services will be a near-perfect replica of EU regulations. However, as clearing is viewed by some EU policy-makers as a jewel of the UK’s financial services sector, the EU may prefer to use equivalence as leverage that is perceived to strengthen its hand in Brexit negotiations with the UK.
“From a perfectly legal and technical standpoint, it makes sense for the EU to give UK CCPs equivalence, but they want to keep political pressure on the UK in their negotiations,” says the UK lawyer.
The lawyer does not believe the EC will grant any form of equivalence until after the current scheduled departure date of October 31, to see what the UK will actually do. The UK prime minister, Boris Johnson, has made clear that he wants to leave on October 31, either with an improved deal from the one negotiated by his predecessor, Theresa May, or without one.
“It will be the exact same situation as last year,” says the lawyer. “UK CCPs will have to serve notices of termination to EU clearing members around Christmas time unless the EU grants an extension. I don’t think we will hear from the EU until after October 31, when things are clearer on what will happen.”
Avoid double jeopardy
Bailey listed several other areas where he said it was necessary for the EU to grant equivalence to the UK, notably the measures to ensure the continuity of outstanding bilateral derivatives contracts between EU and UK firms, and the ability for EU firms to trade EU equities and certain over-the-counter derivatives on UK venues.
Without an equivalence determination for each other’s trading venues, EU and UK firms will only be able to trade instruments subject to their jurisdiction’s trading obligations – known as the share and derivatives trading obligations – on venues in their respective jurisdictions, or those in jurisdictions deemed equivalent by their home legislator.
UK CCPs will have to serve notices of termination to EU clearing members around Christmas time unless the EU grants an extension
A UK-based lawyer
As many of the OTC derivatives caught by the derivatives EU’s derivatives trading obligation are traded on UK venues, Bailey said the absence of an equivalence determination would mean splitting the liquidity pool currently available on them.
Due to UK trading venue operators establishing separate platforms in EU member states, the watchdog for the EC and EU, the European Securities and Markets Authority, has stated it does not see any evidence that EU firms will be unable to meet the EU’s derivatives trading obligation and so there is no urgent need for an equivalence determination.
There are some firms, however, that will be caught by both the EU and UK’s trading obligations, meaning they will not be able to trade on either UK or EU trading platforms without an equivalence determination.
The affected group includes the UK branches of EU firms – Deutsche Bank in London, for example – and UK firms executing on behalf of EU firms as part of an outsourcing arrangement.
The only option for those operations would be to trade on US trading venues that have been granted equivalence by both the EU and UK authorities.
“We will work with EU regulators to try to avoid firms being caught by both UK and EU derivatives trading obligations,” said Bailey. “We believe the right outcome will be for regulators to ensure – where there is a conflict of law – which rule firms should follow, and this would only work if EU regulators were able to do the same. It would be, in my view, a suboptimal outcome if the only place for them to comply with their regulatory obligations is to trade outside Europe as a whole, which is one consequence that could happen.”
This article first appeared in sister title Risk.net.