Warnings Over Moving Euro Clearing

Shanny Basar

Market participants warned that forcing euro clearing to move from the UK to the eurozone will increase costs, risk and operational complexity and diminish the global role of the currency.

The UK has voted to leave the European Union but approximately three-quarters of euro-denominated derivatives transactions are cleared in London and LCH, owned by the London Stock Exchange Group, is the largest global clearer of interest rate swaps. The European Commission is reviewing oversight of central counterparties after Brexit.

Scott O’Malia, ISDA

Scott O’Malia, chief executive of the the International Swaps and Derivatives Association said today that the clearing location policy would increase costs, risk and operational complexity for derivatives users according to a tweet from Isda. O’Malia spoke at Isda’s annual general meeting in Lisbon.

Isda also tweeted that Dr Kay Swinburne, the Conservative member of European Parliiament  for Wales, said that euro clearing location policy would disrupt the market and fly in face of global role of the currency.

The European Central Bank has previously tried to force euro clearing to move away from London into the Eurozone but lost a court case before the EU General Court in 2015. After Brexit the UK may not have the ability to bring a similar case at the EU court.

Valdis Dombrovskis, vice president in charge of financial services at European Commission, said in a speech last week that the Commission will set out a process to consider changes in the supervision of critical clearing infrastructure as a result of Brexit and intends to propose further legislative proposals on CCPs in June. For third-country CCPs which play a key systemic role for the EU, the Commission could ask for enhanced supervisory powers for EU authorities over third-country entities or ask such CCPs to be located within the EU.

“While minimising the risk of market fragmentation, the EU needs to be able to ensure supervisory oversight over such key CCPs,” Dombrovskis added.

Another option is that the European Securities and Markets Authority could be authorize UK-based CCPs as equivalent to EU CCPs. Steven Maijoor, chairman of Esma, said today in a keynote speech at Isda meeting that the regulator is understaffed and equivalency assessment is very resource intensive. According to a tweet from Isda, Maijoor said: “Need to rethink this process.”

Isda also tweeted that that Maijoor said: “Need a mechanism to supervise third-country entities. Not duplicating work of foreign regs, but need to properly supervise risk.”

The Bank for International Settlements said in a report today on OTC derivatives statistics that central clearing, a key element in regulatory reform for reducing systemic risks, made further inroads in the second half of last year.

The BIS began to collect comprehensive data on central counterparties for the first time at the end of June 2016 and found central clearing was less prevalent outside OTC interest rate markets. “Data at end-December 2016 indicate that central clearing is gaining ground in these other segments too,” added the report.

Regulators in most of the major derivatives markets now require certain classes of standardized OTC derivatives, particularly interest rate swaps and credit default swaps, to be centrally cleared.

“While options, foreign exchange derivatives and equity derivatives are generally not covered by these requirements, higher margin requirements for non-centrally cleared derivatives are being phased in, starting in Canada, Japan and the United States in September 2016 and in other key markets in 2017,” added the BIS.

In interest rate OTC derivatives markets, the share of reporting dealers’ positions booked against CCPs stood at 76% at the end of last year, similar to six months earlier. However, central clearing remained negligible for interest rate options, despite the outstanding amount of contracts growing from $53bn to $225bn.

The share of outstanding credit default swaps in central clearing grew from 37% to 44% in the second half of 2016.

“This jump represented the largest semi-annual increase since CCP data for CDS were first collected in 2010,” said the BIS. “The proportion of contracts centrally cleared increased for single-name as well as multi-name instruments, although it remained much higher for the latter (54%) than for the former (36%).”

In OTC foreign exchange derivatives markets, only 1% of notional amounts were centrally cleared, despite the outstanding amount cleared almost tripling in the second half of 2016, from $352bn to $903bn.

The report said: “While the BIS does not collect a decomposition of FX derivatives into FX swaps and forwards, the growth of clearing was probably concentrated in non deliverable forwards because they are one of the few FX instruments that CCPs offer for clearing.”

The BIS added that the notional amount of outstanding OTC derivatives declined from $553 trillion to $483 trillion in the last six months of 2016, and their gross market value – the cost of replacing all outstanding contracts at current market prices – fell from $21 trillion to $15 trillion over the same period. Notional amounts of OTC interest rate derivatives, the largest market segment, fell to their lowest level since 2007 at $368 trillion at the end of last year.

“Trade compression to eliminate redundant contracts has been a major factor,” added the BIS. “Compression was aided by the shift towards CCPs, which in effect multilateralized the compression process.”

Compression is a process in which clients can “tear-up” offsetting trades in their portfolios to reduce the notional outstanding and number of line items in their portfolio while maintaining the same risk exposure. Use of compression services has increased following the introduction of stricter capital requirements, such as the Basel III leverage ratio, which has led to banks reducing their balance sheets and capital efficiency becoming increasingly important.

Last year, for example, LCH’s SwapClear service cleared record volumes of interest rate derivatives and also compressed a record  $384 trillion in notional, boosted by the introduction of the compression of inflation swaps and multilateral compression for clients.


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