Brexit Scenarios for Central Clearing Houses
Brexit Scenarios for Central Clearing Houses are complex - read on to understand the permutations for UK based and European based CCPs, and the likely outcomes. Attached below is the full scale article with more details and updated to reflect the current state of the LSEG-Deutsche Boerse merger activity.
Brexit Scenarios for Central Clearing Houses
Absent of any clear guidance from politicians either from the UK or the EU27 on timing and political grand-standing on all sides regarding demands and tough initial positions, a number of studies1 have been recently published that show how London and its financial services would be impacted.
This article looks at (Derivatives) Central Counter Parties (CCPs), one of the key infrastructures of the financial services market. The increased volumes cleared through CCPs and their increasing global scope, in particular in the OTC derivatives market, make them of systemic importance for the EU Single Market in financial services and requires regulators to manage systemic risks related to them.
Any strategic choice the financial services industry takes pro-actively or any strategy that is forced on it by the political process has to be supported by the underlying market infrastructure. Consequently, the Market Infrastructure sector needs to act in conjunction and in lock step with their clients, but to some extent – due to legal and regulatory lead times – actually needs to front-run the change process in the best interest of their clients. At the same time, it needs to make regulators in the UK, the EU27 and third countries with equivalence regimes confident that systemic risk is not increased as part of this transition. Therefore the market infrastructure sector needs to decide very soon on its own strategic (re-) positioning and the scope of services offered to help clients to transition.
Scenarios to be considered from CCP perspective on Brexit
Given the current state of uncertainty, several Brexit outcomes need to be considered in defining the strategies for the European market in the coming years. With the implementation of most mitigating action taking between 18-24 months, CCPs need to start to position themselves very soon, without certainty on the manner in which Brexit will be negotiated and subsequently implemented:
- Scenario 1 - No Brexit / Status Quo: Decision either not to trigger the Article 50 process or to stop the Article 50 process during the two-year period. The UK would continue to be part of the EU.
- Scenario 2 - Brexit with continued Single Market Access: The UK would be ‘a sovereign and (EU) independent country’ and join the European Economic Area2 (EEA) and thereby continue to have Single Market / EU customs union access. The EEA is based on the same “four freedoms” as the European Community: the free movement of goods, persons, services, and capital among the EEA countries. Thus, the EEA countries that are not part of the EU enjoy free trade with the European Union. For the UK this most likely comes at the price of continued financial contribution to the EU27 and acceptance of the free movement of persons, goods, services and capital within the European Single Market. The status of the UK could in the end be similar to the status of Norway.
- Scenario 3 - Brexit with Privileged Third Country Access: The UK would have ‘privileged third county access’, the scope of which has to be negotiated as part of the transition agreements, and would facilitate the provision of some cross-border financial services - such as CCP services - from the UK using equivalence provisions e.g. under EMIR.
- Scenario 4 - Brexit within WTO GATS Framework: The UK exits the EU with some transitional arrangements, losing most preferential access to the EU27 Single Market. The UK would only have access to the EU27 based on bilateral trade agreements under the World Trade Organisation (WTO) and General Agreement on Trade in Services (GATS) framework and have the status of a ‘most favoured nation’. There would be the need to negotiate additional bilateral agreements similar to the current arrangements between the EU and Switzerland. This may require a ‘softer’ Brexit than the one currently contemplated by the UK. Currently the UK will not accept, it seems, any EU freedom of movement rules and the supremacy of the European Court of Justice (ECJ).
- Scenario 5 - Uncontrolled Brexit (‘Brexident’): No agreements are reached in the Article 50 process or a withdrawal agreement is reached, but no transitional arrangements, and the parties fail to extend the two-year period by mutual consent. The UK exits the EU with no or minimal transitional arrangements, losing most if not all preferential access to the Single Market. The de facto outcome is similar to Scenario 4, but probably more random and abrupt, as initially no additional bilateral agreements with the EU would have been negotiated.
Table 1 Brexit Scenarios
In Scenario 2 and 3 respectively there is some likelihood that Euro-denominated products would be excluded from a passporting regime.
Already in July 2011 the European Central Bank (ECB) published its Eurosystem Oversight Policy Framework, which argued that clearing houses based in the UK or other non-Eurozone countries would have to move inside the Eurozone to continue to do business in Euros. The UK successfully challenged the policy in September 2011 in the ECJ, which in March 2015 ruled, that “the ECB lacks the competence necessary to regulate the activity of securities clearing systems as its competence is limited to payment systems alone by Article 127(2) of the EU Treaty.”
One of the key reasons for the ECJ’s decision was the concern that the ECB policy would create a damaging split in the Single Market in Financial Services. However Brexit is now triggering this damaging split on a much broader scale. Therefore it is very likely that the discussion to clear Euro-denominated products with the Eurozone will re-emerge and this time with substantial political support by the Eurozone countries, some of which are aiming to become the new clearing hub within the EU27. Both Paris and Frankfurt have announced their ambitions. Beside the ambitions of other financial
centres in Europe a good argument can be made that CCPs responsible for the clearing of the majority of business in some Euro-denominated products are systemically important for the EU27 and need to be regulated, supervised, stress tested and worst-case unwound by the EU27 as they have systemic importance for the Single Market in financial services. However to force the clearing of Euro-denominated products into the Eurozone either the ECB’s powers under Article 127(2) of the EU Treaty would need to be extended to cover clearing, requiring unanimous support from member states, including the UK; or, alternatively, the European Council would need to amend regulation to change the rules on the location of CCPs – e.g. within the EMIR framework -, which would be subject to majority voting in the Council and Parliament of the EU. In both cases there would be some months lead-time for the market to adjust due to the required process for all parties to adjust their strategies. However such a lead-time might not be sufficient for all players, especially the UK CCPs.
Scenarios 4 and 5 also require a careful consideration: Both scenarios would be economically damaging for EU27 as well as the UK, but seem very likely if only one of the parties involved insist on political ideology3. This is why CCPs need to give them serious consideration, especially as there have recently been many tendencies within different European countries to prioritise national interests and there will be many general, presidential and parliamentary elections in the next two years, i.e. in France, Germany, the Netherlands and Norway in 2017 and in Belgium, Finland, Luxembourg, Ireland and Italy in 2018. This might lead to shifting positions, posturing and inability to compromise during political campaigns, delays and uncertainties during the negotiations. Finally there will also be an election of the European Parliament, which also has to consent to any withdrawal agreement, and is foreseen for May /June 2019, vey close to the currently intended end of Brexit negotiations, which might lead to additional delays if the outgoing parliament does not want to take such an important decision.
For scenarios 3 – 5 a time gap between Brexit and the implementation of EU27 access under an equivalence regime of 10 – 18 months might be a possibility: Unless during the Brexit negotiations an appropriate solution is agreed (e.g. Scenario 2), UK CCPs and UK financial services institutions will no longer benefit from the financial services passport after Brexit. In this scenario, the UK would be a ‘third country’ in EU regulatory terms, and subject to the third country access provisions of EMIR (CCPs) and MIFIR (financial institutions), where the EC may adopt implementing acts declaring that the legal, supervisory and enforcement arrangements of a non-EU country are equivalent to the requirements in EMIR /MIFIR.
The process of obtaining an equivalence determination from the European Commission (EC) may seem straightforward given that the UK has implemented EMIR and is likely to implement MIFIR and all other relevant EU legislation until Brexit. However from a process perspective ESMA (following a 30 working day period to confirm that an application for an equivalence determination
is complete) has 180 working days to decide whether
equivalence registration should be granted. The theoretical time frame for an equivalence decision therefore is about 9 – 10 months, however deciding on the equivalency of the regimes in the US, Hong Kong and Singapore, took ESMA substantially longer.
If the EU27 are not willing to run the equivalence decision process from an early stage in parallel with the withdrawal negotiations, there could be a substantial time gap between Brexit and the point in time where CCPs and financial institutions could again
access the EU27. This disruption would force UK market participants – theoretically at least for an interim period – to set up operations in EU27 and to switch to CCPs within the EU27 to service EU27 clients. However it will be practically close to impossible for UK CCPs to gain back their original business after a time gap of 9 – 24 months, so the de jure time gap equals a de facto non granting of access.
A time gap scenario becomes likely if the EC take the position that the equivalence assessment process cannot start until the final regulatory structure in the UK is defined (i.e., after the Brexit negotiations are concluded). Given that some EU27 countries are already lobbying for CCPs and financial institutions to move their operations to them and given that many EU politicians are openly hostile to the prospect of the UK financial services sector maintaining market access post Brexit, this outcome from today’s perspective is not unlikely and needs to be considered4.
Challenges for UK based CCPs
UK CCPs today can passport their services throughout the EU under EMIR. This capability might be unchanged under scenarios 1 and 2, where Single Market access remains. However from today’s perspective scenario 1 seems quite unlikely as the next election in the UK is not expected to be until 7 May 2020 and scenario 2 seems unlikely with the current ‘hard Brexit’ approach.
UK CCPs might continue to passport their services – potentially with some limitations, e.g. regarding (Euro-denominated) products - in both scenario 2 and 3 leveraging equivalency under EMIR. This would allow all UK CCPs or trade repositories to provide their services in the EU27. Cross-Border investment services in addition could be provided und MiFID2 / MiFIR and expected to be implemented in early 2018. The exclusion of Euro-denominated products from this passporting would have a severe impact on the current business.
Under scenarios 4 and 5 the UK CCPs would lose access to the Single Market and all third country markets under EMIR equivalence. Having said that, scenarios 4 and 5 not only have the gravest impact and longest lead-time to mitigate they also will only crystallise very late in the Brexit negotiations/process. Therefore the lead-time to mitigate might not be sufficient for all UK CCPs.
Challenges for EU27 CCPs
Under scenarios 1 and 2, where Single Market Access remains, nothing changes for the EU27 CCPs. However, if there were to be a political price for the UK to pay in scenario 2 regarding the clearing of the Euro-denominated products within the Eurozone, the Eurozone CCPs would be big winners.
Under scenario 3 there would be reciprocal or equivalent conditions for the Continental CCPs to access the UK, so nothing much would change. However, if clearing of the Euro-denominated products would have to be within the Eurozone, the Eurozone CCPs would be big winners.
Under scenarios 4 and 5 where the UK CCPs would lose access to the Single Market the same is true to the CCPs clients, the banks, brokers and institutional investors. In such a scenario these market participants would be forced to establish full-scale operations and move substantial parts of their balance sheets into the EU to continue to serve their EU27 customers. In this case it is very likely that these clients would need EU27 based CCPs to support their business and to comply with EU regulation on mandatory clearing and manage their balance sheet and capital requirements. At the same tie they would have to move (euro-denominated) collateral into CSDs, Custodians and sub-custodians within EU27. In addition there might be an incentive for such clients to move all their business from the UK into one Eurozone CCP to pool all positions and collateral to maintain / achieve maximum netting efficiency. This means that EU27 CCPs would not need to follow their clients to the UK, but that the clients would be forced by regulatory needs to come to them. Alternatively, some clients might want to use a US CCP or Asian CCP that could provide services in EU27 products or economically equivalent products in Euro under the equivalence framework. Different strategies by CCP clients might lead to more fragmentation of the business between the UK, EU27, the US and Asia, especially when adding Financial Transaction Taxes (FTT) and different costs of risk management into the mix.
Challenges for EU associated CCPs
On a side note, CCPs in countries such as Switzerland and Norway, which will continue to participate in the Single Market of EU27, would probably need to ensure that their governments enter into bilateral agreements with the UK, to allow them to also offer services in the UK under passporting or equivalence regimes or they need to consider setting up CCP subsidiaries in the UK and the EU27, if EU27 CCPs could continue to access the UK.
- BBA, Clifford Chance, Global Counsel: “UK exit from the EU: an orderly transition for banking”, August 2016.McKinsey & Company, Clifford Chance: “After the referendum: Which European Business Model Strategy should Banks Pursue now?”, July 2016. Oliver Wyman: “The impact of the UK’s exit from the EU on the UK-based financial services sector”, September 2016
- See http://www.efta.int/sites/default/files/documents/legal-texts/eea/the-ee...
- See CNBC, “France plays hardball over the UK’s financial passport”, 12.10.2016, http://www.cnbc.com/2016/10/12/france-plays-hardball-over-the-uks-financ...
- See: Davis Polk and Wardwell London , Lex et Brexit — The Law and Brexit: “The third country passport under MifIR – panacea for post passport pain?”, July 9, 2016.
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