PRIMER: Emir 2.2
Changes could pull clearing away from the UK and back into the EU
In March 2015, the European Central Bank was defeated in the European Court of Justice after attempting to restrict euro-denominated clearing to the eurozone and away from the UK. The new European Market Infrastructure Regulation (Emir) effectively means the EU finally has its wish after more than three years of waiting.
What is it?
Emir regulates over the counter derivatives, central counterparties (CCPs) and trade repositories and came into force in August 2012. Six years on, the size of CCPs has grown and the cross-border dimension has changed, but more pivotal is the UK’s decision to withdraw from the EU, placing a greater importance on the role of third-country CCPs given that 75% of centrally-cleared interest rate derivatives denominated in euros are cleared in the UK. This has forced European regulators to act.
Originally, Emir changed the way derivatives were traded and executed, moving clearing eligible transactions out of the over the counter market and into the CCPs. This has meant a lot of market activity previously on the fringes is now very much in the spotlight. But this transition has not been without problems, and a debate has been ongoing as to whether the current framework is the most effective one possible.
A European Commission impact assessment found two major problems with the current framework: one that there is an incoherence with arrangements for the supervision of CCPs established in the EU and also insufficient mitigation of risks relating to the operation of recognised third-country CCPs. The current supervisory frameworks are considered problematic.
"The carrot is that CCPs will have greater access to European markets, the stick is that they may have to relocate"
What are the changes?
Enter Emir 2, which aims to address these issues and help to protect a segment, which is one of the most at risk due to Brexit. To do this, the proposal so far has called for enhancing CCP supervision and central bank of issue role at EU level, and enhancing the EU’s ability to monitor, identify and mitigate third-country risks.
In May, the European Parliament accepted the Commission’s proposal, confirming that the business of clearing financial transactions in euros will remain in the single market post-Brexit and will move into the eurozone. To do this, and increase the oversight of the EU on CCPs, plans are to: alter the recognition procedure for third country CCP dependent on their systemic importance; expand the European Securities and Markets Authority’s (Esma) supervisory role; and, most notably, introduce a relocation power to inside of the EU for CCPs to gain EU market access.
As well as Brexit and a changing CCP environment, the changes are also said to be instigated as a result of the Greek debt crisis. Regulators want to ensure that all CCPs with access to European markets all play by the same rules.
Michael Huertas, partner at Dentons, said the relocation power is a last resort option, but over time the breadth of what is offered and where will depend on how quick current CCPs can adapt to a changing market.
“It’s almost secondary whether it’s CCPs who choose to move business or regulators telling them to,” he said. “For the moment, we constantly hear the differentials in pricing and thus liquidity is a problem for users of CCPs.”
That affects not just clearing members but their counterparties and clients for the short term but is likely to change as the market evolves.
The degree of EU supervision will be proportionate to the risk posed by the third-country CCPs. Those in the lowest tier will be supervised with a light-touch level of supervision exactly the same as now. Those considered more systemically important or impactful would have additional requirements imposed upon them; for example, they would need to comply with different requirements for any instrument which is to be cleared and more enhanced supervisory requirements.
Finally, the ultimate backstop is for those considered to be the most systemically important third country CCPs. There is a residual right to relocate these into the EU, a power the EU has desired for some time. This means setting up a new entity, which could be a long, difficult and expensive process.
“The carrot is that CCPs will have greater access to European markets as a result, but the stick is that they may have to relocate whether at the request of the regulator or otherwise,” Huertas said.
Why the changes and what impact?
Because it is fairly unclear as to what is considered a systemic risk, there are concerns that the relocation tool could be used politically, particularly in the context of Brexit. Debate has been ongoing since the referendum result as to whether euro-clearing should remain in the UK or should remain in the EU.
Even though the focus has been on third-party CCPs, the changes are also going to have a big impact on EU-based CCPs, which will be under greater scrutiny. After the first version of Emir, EU-based CCPs were required to apply for authorisation with a national competent authority and were supervised by a group of national supervisors. But this is considered to be insufficient without greater centralisation and greater coordination from Esma and the ECB. Supervisory standards remain misaligned and there are differences in supervision of third-country CCPs, which will become all the more crucial next year.
Esma will have greater powers for supervision and will set up a new committee to centralise decision-making. National authorities will have supervisory power over CCPs, but must consult with Esma first and gain prior consent before using their powers. This could be a challenging relationship.
“I do think there is a risk a tension could be created between the European authorities and a third country CCP's home state regulator, when European authorities seek to influence the CCP's risk management policies that affect EU instruments or currencies,” said Michael Thomas, partner at Hogan Lovells.
There could be different objectives to those of the home state regulator, which would be typically trying to ensure that the CCP is managed on a prudent basis from a risk-management perspective.
There could also be a problem if a Greek-style scenario arises, which could create tension between the ECB and the interest of the CCP regulator that is wanting to ensure it remains fully collateralised. It is not clear how this would be resolved and would require dialogue between both to come to a successful conclusion.
As well as levelling the playing field from a member state perspective, it also levels the playing field from a commercial perspective and reduces the risk of regulatory arbitrage.
While the UK will inevitably be concerned by rules that will take some of the power out of their hands from an industry so valuable to them, concern has also been expressed by US regulators who will also be affected by the changes to the third-country CCP rules.
Commodities Futures Trading Commission chairman Christopher Giancarlo said if European regulators do not defer to the US’s supervision over its CCPs then they will cut off EU firms from US markets.
In 2016, the EU and the US reached an agreement to mutually recognise each other’s clearing regulatory frameworks, but debate began after the UK’s referendum result that this should be reconsidered. The new proposal changes this relationship.
“Each jurisdiction could be deemed equivalent, but the relocation power suggests there may be circumstances where a specific CCP could still be required to relocate if it becomes sufficiently systemically important to EU financial stability,” said Kerion Ball, global markets partner at Ashurst. “This is the crux of the problem.”