Market risk looms following Esma equivalence announcement

By Emma Olsson | 2 October 2020

With Brexit negotiations still pending, the European Securities and Markets Authority (Esma) risks perpetuating instability with an extended European Markets Infrastructure Regulation (Emir) equivalence period.

“The EU were firm in their statement that they expect firms to reduce their exposure to systemically important UK clearing houses. The risk is that if firms have not made the requisite changes and there is no permanent equivalence decision in place at the end of the 18 month period, firms will lose access to the liquidity on which they currently rely,” says Craig Pearson, director at Margin Tonic, a consultancy.

On September 28, Esma announced that three UK central counterparty clearing houses (CCPs) – LCH, ICE Clear Europe and LME Clear – would be eligible to provide services in the EU as third country CCPs following the UK’s withdrawal on December 31. This followed news that the EU would allow UK CCPs a period of 18 months to continue clearing euro derivatives the year ends, announced by the European Commission on September 21.  

The news was welcomed by industry bodies such as the Association for Financial Markets in Europe (AFME), but uncertainty lingers surrounding the systemic importance of UK clearing houses and the potential requirement for European firms to switch CCPs after the equivalence period.

Allan Yip, partner, derivatives practice at Simmons & Simmons LLP, hopes the equivalence decision will allow for a smooth transition.

“When I speak to my clients about this issue, the view seems to be more that the additional 18 months allows things to continue as before, with the hope and expectation that UK CCPs will be granted permanent equivalence and recognition, in the same way that US and other non-EU CCPs have been,” he said in an email.

LCH currently clears over half of all OTC interest rate swaps – a position not unnoticed by European regulators. In this week’s announcement, Esma stated that the 18-month equivalence period will offer time to review the systemic importance of UK CCPs.

“Many European firms rely on access to UK clearing houses to hedge their borrowing costs and the LCH currently clears the largest proportion of the Euro denominated swaps. The EU recognised that in their recent decision – they knew that any abrupt removal of access would have consequences to market stability,” says Pearson on the “perceived reliance” of European banks on UK CCPs.

A condition of the equivalence period is that the UK operates a comparable regulatory framework to Emir. While this condition seems likely under the Financial Conduct Authority’s (FCA’s) Temporary Transitional Power (TPP), Pearson says pending Brexit negotiations are still cause for anxiety.

“There remains a huge amount of uncertainty with the current Brexit negotiations and so it’s understandable that many firms will elect to see what happens in the next six months, but firms cannot wait indefinitely before making appropriate change to their processes,” he says.

“A lot will depend on the services that the Eurozone CCPs develop in this period – if the volume and liquidity exists within the Eurozone, we are more likely to see the European banks make the switch earlier.

Yip agrees.

“I think everyone is clear that the additional 18 months shouldn’t treated as permitting the industry to stick the problem in a draw for a year or so and then try to deal with it again in the run-up to June 2022. However, there must be a decent-sized chance that this is exactly what will happen.  There is a significant political angle on this as well, which will muddle the waters quite a lot,” he said.


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