Counting on clearing

24 October 2018

There has been significant discussion on both sides of the channel on the impact of a no deal Brexit on the UK’s economy. This is unsurprising considering the EU-27 is the UK’s largest export market. But when it comes to  financial services, the scale of the UK market means that this relationship is reversed. Nowhere is this more pronounced than in the area of clearing of derivative trades.

For such a technical activity clearing has attracted a huge amount of political and press attention since the Brexit referendum. This is perhaps because of the sheer scale of London’s clearing market to that of other EU27 locations. For example, The London Clearing House (LCH) clears swaps in 18 currencies for firms in 55 jurisdictions, handling over 90% of cleared interest rate swaps globally and 98% of all cleared swaps in euros. For some products, such as metals derivatives, The London Metal Exchange (LME) is the only CCPs in Europe that clear them.

The importance of the clearing market in London has come into increasing focus in recent weeks as the implications of a no deal Brexit for the market come into stark focus. Under EMIR (the EU’s regulation which governs the derivatives market) EU banks can only be clearing members of qualifying CCPs (QCCPs) and those derivatives subject to the clearing obligation must also be cleared through a QCCP. CCPs located in third countries can be deemed to be QCCPs, but this requires them to be recognised by ESMA and located in a jurisdiction deemed to be equivalent by the European Commission. Currently thirty-two third country CCPs are recognised by ESMA to provide services in the EU, from countries as diverse as India and New Zealand.

In a no deal scenario the UK will have regulation in force identical to EMIR and UK CCPs are subject to robust supervision by the Bank of England. So why is there a risk of UK CCPs losing their QCCP status? In part it is because there is currently no mechanism to deem a country equivalent whilst they are still an EU member state. This means should the UK leave the EU in March 2019 there would be an inevitable gap between Brexit and any equivalence decision.

In practice UK CCPs will be forced to give at least three months’ notice to EU-27 clearing members informing them they will need to find alternative clearing arrangements. Once served notice, EU firms will have to to attempt to trade out of their positions.  If they are unable to, at the end of the notice period they will be deemed to be in default by the CCP, resulting in the margin they have posted at the CCP being auctioned, in potentially very difficult market conditions.

What would be the impact of this on the market? It could be very severe. The Bank of England estimates around £41 trillion of derivative exposures could be impacted by a hard Brexit. In many cases there is no credible short term alternative to clearing in the UK and with a significant part of the market attempting to exit positions at the same time, market capacity will be severely stretched. Should EU banks be deemed to have defaulted on their positions, the impact on their solvency could be significant. Further, EU corporates may find that the risk management services provided to them by EU-27 banks become more expensive and specific services may not be possible at all.

What can be done to prevent these risks? First, it’s worth noting that, on balance, a deal still seems more likely than not. But even in a no deal scenario, steps could be taken to address the most severe effects on the derivatives market. In the UK the Government and regulators have announced they will implement a temporary permissions regime in the event of no deal, to allow EU financial services firms to continue providing services into the UK on a time limited basis. No similar commitment has been made by the EU. ISDA and a number of EU-27 trade associations recently published a paper setting out the risks from a no deal Brexit. In it they set out a number of recommendations, including temporary recognition of UK CCPs by the EC and ESMA in the event agreement between the UK and EU cannot be reached.

Central clearing was mandated by the G20 to reduce systemic risks and reduce opacity in the OTC derivatives market. To preserve these benefits and to reduce the likelihood of avoidable systemic risks, a commitment is required from the European Commission and other EU authorities that they will take steps to mitigate the cliff edge risks. To have the desired impact it must occur before CCPs start to issue termination notices, this cannot wait until midnight on the 28 March 2019, as certainty for market participants is needed in the coming weeks.

 

Andrew Gray

Andrew Gray | Partner
Profile | Email | +44 (0)20 7804 3431

Connor MacManus

Connor MacManus | Senior Manager
Profile | Email | +44 (0)20 7213 8555

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