London’s LCH is expected to start serving cancellation notices to around a third of its SwapClear members before year-end if no arrangement is made for EU firms to continue using the world’s biggest swaps clearing house after Brexit.
Under the terms of LCH’s rule book, members could be given just three months to transfer an estimated £38 trillion ($49 trillion) in swaps notional to alternative venues. The scenario has been widely discussed by banks and other clearing houses in recent months, and reflects concerns among non-EU members that their EU peers wouldn’t be able to fully participate in the central counterparty (CCP) following the UK’s departure from the bloc – for example, EU members would be unable to bid during an auction of a defaulting firm’s portfolio.
“If nothing happens between now and March 29, you need all EU members to have exited as they can’t continue to be members,” says a regulatory head at one European bank. “If you can no longer participate in a default auction, you are no longer respecting the rule book, so you can certainly understand that UK CCPs are under pressure from other members.”
The EU was urged to head off that turmoil on October 3 by the continent’s top markets regulator, Steven Maijoor, chair of the European Securities and Markets Authority (Esma). Speaking at a conference in Athens, he called for the EU to quickly finalise year-old proposals on the treatment of third-country CCPs – part of an update to the European Market Infrastructure Regulation – and to separately approve temporary permission for EU firms to continue using LCH and other UK clearing houses.
“I would support a swift conclusion of the Emir 2.2 legislative file, complemented by a transitional provision allowing for the continued access to UK-based CCPs,” he said.
Maijoor argued such access is in line with proposed Emir changes that allow “under certain conditions, systemically important CCPs and non-systemically important CCPs from third countries to provide services in the Union.”
The problem arises in a no-deal Brexit scenario, when UK clearing houses would become third-country CCPs. Article 25(1) of Emir states that CCPs in third countries can only offer clearing services to EU members if the clearing house is recognised by Esma – but recognition could only be applied for after the point of the UK’s departure, and might not be granted under the proposed changes to Emir, which are set to introduce tougher standards for systemically important CCPs.
If nothing happens between now and March 29, you need all EU members to have exited as they can’t continue to be membersRegulatory head at a European bank
The definition of “clearing services” has been hotly debated, with some suggesting it applies only to new trades. But even if existing trades could be left at UK CCPs, the prohibition on new trades would prevent EU members from meeting clearing house rules – in the event of a default, a CCP’s route back to safety involves auctioning off the stricken firm’s positions to its surviving members. This would make it “close to impossible” for EU members to meet their risk management obligations, according to an executive at a non-UK clearing house.
“If you can’t add new trades, how are you going to manage the risk profile of your legacy portfolio and how are you going to manage your commitment in the default management process of the CCP? Buying part of a potentially defaulting portfolio means you’re adding new trades, which you wouldn’t be allowed to do,” he says.
That leaves UK CCPs between a rock and a hard place. Cancellation of members is viewed as the nuclear option, requiring the market to facilitate the transfer of huge amounts of risk to alternative venues. But non-EU clearing members are equally concerned about non-cancellation. If EU members aren’t turfed off the platform in a no-deal scenario, non-EU firms fear they could be required to pick up the tab in the event of a member default.
“If there isn’t going to be some kind of transition period, then we need to think about what the CCP should do to ensure it doesn’t have any exposure to the risk that a clearing member couldn’t perform its obligations,” says a senior clearing executive at a US dealer. “If they [LCH] don’t issue retirement notices, clearing members in general could be concerned there’s a big risk about some members’ ability to manage their risk.”
By the book
LCH remains tight-lipped on any Brexit contingency plan and declined to comment on cancellation notices. LME – Europe’s biggest market for metals futures and options – also declined to comment on its plans.
The rule books of each venue outline what is possible. Regulation 5(i) of LCH Ltd’s rules specifies a three-month notification period for forced resignations. This implies the CCP would have to issue a written notice to EU27 members by December 29 to ensure they have closed out their positions by the date of the UK’s departure on March 29, 2019. In reality, those notices would probably be issued earlier – in late November or early December, according to an over-the-counter derivatives clearing head at one European bank.
Rule 3.11 of LME Clear’s rulebook gives the metals clearing venue the right to withdraw services to a category of members with a notification period of just 30 business days. This could be reduced further if required by law, or at the instruction of a regulator, the rules state.
Despite the last-minute termination option at its disposal, LME Clear is understood to be preparing to give EU clients as much warning of any cancellation as possible.
Even without termination, hefty capital charges leave little incentive for EU members to continue using non-qualifying CCPs. Bank capital rules slap a risk weight of 20% on exposures to non-qualifying CCPs, compared to just 2% for qualifying venues.
“The greatest uncertainty is about existing trades and whether they could continue to exist on LCH. The punitive capital treatment associated with the non-QCCP status would probably dictate what the outcome of that is,” said Laura Muir, head of the legal team responsible for strategy and bank structure at Barclays, speaking at an industry event last week.
Around 40 of LCH SwapClear’s 111 members are based in the EU27 and face possible cancellation.
EU-based clearing members at LCH are already in discussion with alternative venues to transfer interest rate swaps away from London.
“Customers are reaching out to us and other CCPs to see if they can transfer their legacy swaps. They’re making sure they have options by connecting to alternative CCPs,” says the executive at the non-UK clearing house.
In some cases, this would require the business to leave Europe altogether. For interest rate swaps, Eurex – a possible destination for some EU firms – only clears nine currencies compared to LCH’s 21.
For swaps denominated in Czech koruna, Hungarian forints or South African rand, for example, EU27 members currently using LCH would have to go to the US, where CME Clearing – already deemed equivalent by EU regulators – matches LCH’s currency set. Clearing for US dollars, Hong Kong dollars and yen is also expected to go to the US or Asia.
EU firms trading metals contracts would be forced to transfer their exposures from LME Clear to the US and Asia, given there are no alternative venues offering those products within the EU27.
“There is a risk to Europe as a whole, because if the derivatives market moves anywhere in the world, it will be to the US or Singapore,” said Catherine McGuinness, chairman of policy and resources for the City of London, speaking at a conference organised by the International Swaps and Derivatives Association in London last week. “We need to work together make sure it remains here in Europe and avoid slipping into protectionism and market fragmentation. We need to work together on the consumer-focused case to ensure derivatives markets remain global.”
The UK Treasury warned in August that EU clearing members could be cut off from UK CCPs without an EU equivalent of draft UK legislation for temporary recognition. The UK temporary recognition regime enables EU CCPs to continue offering services in the UK for up to three years while they seek formal recognition. Although there has been no word from the EU on a matching regime, EU regulators – unlike their UK counterparts – already have the power to grant temporary permission to third-country venues.
“Since the beginning we identified [clearing] as a cliff edge. We are aware of that,” said Sebastien Raspiller, head of the financial sector department directorate-general of the Treasury at the French ministry of Economy and Finance, speaking with McGuinness last week. “The good news is that we don’t need to have a deal between the UK and EU to avoid this cliff-edge risk, we can do it unilaterally from both sides. We don’t have to rely on a political agreement to be signed and ratified by each of the EU27.”
He warned the timetable could be difficult. Under the current legislative framework, Esma is not able to recognise a UK clearing house as a third-country CCP under Emir until the country ceases to be EU member state. That, however, would be too late to stop CCPs serving notice on their EU clients.
Speaking at the event in Athens, Esma’s Maijoor described the current framework as a “legal obstacle”. He also called for memorandums of understanding to be put in place between national competent authorities, Esma and their UK counterparts – “the type of MOUs that we have with a large number of third-country regulators” – to ensure effective supervision and enforcement in the event of a no-deal Brexit.
According to the Bank of England’s Financial Stability Report released in June, EU clients represented £67 trillion of cleared notional derivatives at UK CCPs, of which £38 trillion will mature after the first quarter of 2019. As the exit date draws closer, the proportion of swaps maturing after the deadline will grow.
Traders say it would be a dangerous task to transfer such a large amount of open interest in a short space of time, particularly with no formal mechanism to aid the shift. Cleared swaps can’t simply be transferred to another venue – they have to be offset with opposing positions, compressed to zero, and then executed anew at a different venue. The concentrated demand for new trades could produce volatile prices.
“There’s no easy mechanism for de-clearing or porting a trade from one clearing house to the other. The point of clearing is that it’s not one trade, it’s two trades. There’s an equal and opposite trade established with the other party to the executed trade so you’re not just talking about the EU clearing manager side of the trade, you need to persuade the other side of the trade to move as well,” said Barclays’ Muir, speaking at the Isda event.
She added: “To the extent there is capacity in another clearing house which does have QCCP status, when you start getting into that, you’re talking about re-executing trades, re-establishing trades on other platforms, clearing members ending up with split exposure across CCPs and inefficiencies in margining and netting, then it does start to become quite a big problem and one that cannot be solved by firms themselves.”
Trading platforms such as Tradeweb and BGC offer services that aim to simplify the multi-step process of closing out and rebuilding positions elsewhere, but those services are untested for a mass transfer. New tools may soon be available, however. Nex Group is understood to be working on a service via its Reset division that could port cleared derivatives exposures between CCPs. A spokesperson for Nex declined to comment.
There’s no easy mechanism for de-clearing or porting a trade from one clearing house to the otherLaura Muir, Barclays
Examples of smooth transfers of derivatives open interest do exist. For example following the closure of Dutch multilateral trading facility The Order Machine in 2017, open contracts were transferred from Ice Clear Netherlands to Paris-based LCH SA.
“In history, when CCPs co-operate there is a precedent that you can transfer open interest. With LCH being so extremely large in swaps, this is still a huge exercise though,” says the clearing head.
Time has also run out for LCH to replicate its SwapClear services at its Paris entity, LCH SA, which would allow EU members to shift exposures onshore. LCH SA, which clears credit default swaps and repo trades, would need to achieve the appropriate authorisation to add interest rate swaps – something that is out of reach within the current timescale.
Clearing heads at two CCPs estimate authorisations would take between six months and two years to obtain, and warn UK clearers would probably facing a long wait, given the political dimension of such a decision.
Another option – to revive LCH’s US-based subsidiary, SwapClear LLC – is also off the table according to some market participants. The US CCP, which launched in 2013 as an attempt to win onshore US swaps clearing activity, is now just an empty shell after all open interest was consolidated in London in 2016.
Listed markets are already in advanced preparations to transfer positions out of the UK. Dealers are expected to begin transferring clients’ futures and options positions to EU affiliates this month using a protocol developed by the FIA, an industry group.