EU firms face margin threat as Brexit tips futures into OTC regime

Mid-2021 clearing, margin thresholds loom as LME, Ice futures lose exchange-traded status in EU

Post-Brexit-frictions

European Union-based users of some popular UK-listed commodity contracts saw their trades reclassified as over-the-counter on January 4 after the Brexit transition period expired without a deal on equivalence for trading venues.

Brent oil contracts at Ice Futures Europe and aluminium futures traded at the London Metal Exchange (LME) are among the affected contracts. EU corporates that continue to trade the contracts must meet additional reporting requirements and could face greatly increased margin costs from mid-2021 if they breach regulatory thresholds for OTC exposures. 

“For many of these contracts, there are no alternative trading venues, which means you are stuck with a stark choice between coming subject to higher risk management and collateral obligations or you have to reduce your business,” says Karl Peter Horstmann, head of markets regulation at RWE Supply and Trading.

The reclassification of exchange-traded derivatives (ETDs) is one of the more peculiar by-products of a bare-bones Brexit deal that excludes financial services. The EU’s European Market Infrastructure Regulation (Emir) treats contracts as OTC if they are not traded on EU-regulated markets or third-country markets deemed equivalent under Article 2a of the regulation.

The worry among European corporates is that reclassified commodity contracts could cause them to blow through a €3 billion ($3.7 billion) threshold for OTC commodity derivatives, catapulting firms into the category of larger non-financial corporations (known as NFC-plus under Emir rules). This would mean subjecting them to costly clearing and margining obligations.

“The change to NFC-plus status has a cliff-edge effect and it’s something most firms want to avoid,” says RWE’s Horstmann.

Race against time

OTC reporting requirements take immediate effect for the de-recognised UK ETDs. However, NFC-minus firms are able to rely on their financial counterparties to report most of their trades, and some NFC-minus firms already have their own reporting infrastructure. As a result, the surge in reported OTC derivatives notionals is the most pressing concern for corporates, in case it drives them into the NFC-plus category.

Clearing thresholds, which are calculated in May and June, are set for each asset class: €1 billion for equity and credit derivatives, rising to €3 billion for rates, foreign exchange and commodities. Once a firm passes the threshold, it will retain NFC-plus status for at least a year, until the next NFC calculation is performed.

A breach in any single asset class would subject the firm to any clearing obligation within that asset class, while all non-cleared trades in any asset class undertaken by the NFC-plus would also be in scope for bilateral margining.

Although hedging transactions remain exempt from the threshold calculation, Horstmann says that notionals can quickly add up, particularly in energy trading divisions where turnover can be high and firms often enter additional contracts to terminate existing exposures.

“We have regulatory monitoring in place to see how close we come to threshold,” he says. “At some stage, we will face a choice between reducing trading activities or continue trading and having to put up hundreds of millions in collateral for all uncleared OTC derivatives across the entire corporate group, but that’s going to be too expensive.”

EU traders of UK-based commodity contracts have few alternatives at their disposal. Many LME metals contracts have no equivalent at EU-recognised venues. While Brent oil futures are also traded at CME in the US – an EU-recognised market – open interest equates to around 150 million barrels. This compares to 2.5 billion at Ice. Many European firms would also face a cumbersome repapering effort to access US markets.

At some stage, we will face a choice between reducing trading activities or continue trading and having to put up hundreds of millions in collateral
Karl Peter Horstmann, RWE Supply and Trading

Industry groups cranked up their lobbying efforts in late 2020. A group of nine trade associations led by the European Federation of Energy Traders (EFET) warned in a November 27 letter to the European Commission that attempts by EU corporates to avoid breaching the OTC clearing threshold would “hinder their risk management capabilities as well as their business opportunities and further development in global markets.”

A further group of seven trade associations led by the Futures Industry Association and International Swaps and Derivatives Association sounded similar alarms in a November 30 letter to the EC, warning a lack of equivalence for UK venues would “create an uneven playing field and operational challenges for EU banks and investments firms and will ultimately impact corporate end-users and the real economy in the EU.”

Hopes for a resolution were bolstered in early November, when the UK issued an equivalence ruling for trading venues across the European Economic Area. This ensures UK firms can continue to treat listed derivatives traded on European venues as ETDs under the UK iteration of Emir Article 2a. The UK Treasury signalled its hope that this move would encourage reciprocation from the EU, but so far this has not been forthcoming.

Financial services were omitted from the EU-UK trade and co-operation agreement reached on December 24 – just six days before the UK dropped out of the single market. In a statement on the trade agreement, the EC noted 28 areas where it was yet to take decisions on UK equivalence and acknowledged the UK’s equivalence ruling. “The commission has taken note of the UK’s equivalence decisions announced in November, adopted in the UK’s interest. Similarly, the EU will consider equivalence when they are in the EU’s interest.”

 Esma-offices-man.jpg
Esma has recognised 37 third-country exchanges as equivalent for the purposes of Emir since 2016

Some participants remain optimistic for trading venue equivalence to be included in a memorandum of understanding, expected to be agreed between the UK and EU during the first quarter.

“With the trade deal, there is now a place for those negotiations and assessments to go in the right direction and hopefully equivalence decisions will be forthcoming soon, because it is in the interest of EU firms,” says Corinna Schempp, vice-president for European policy and regulation at the Futures Industry Association.

Since 2016, the European Securities and Markets Authority has recognised 37 third-country exchanges, across Australia, Canada, Japan, Singapore and the US.

“If you look at the list of equivalent exchanges published on the on the Esma website, I would be amazed if the sophisticated UK platforms would not be part of that list as well in the future, given the standards that they set, and also the leading nature of their developments,” says Robbert Booij, chief executive for Europe at ABN Amro Clearing. “And of course, the UK regulatory framework is not only similar, it is basically identical to the EU framework.”

However, some worry an agreement could enter into force too late for many firms. “We’re probably talking about a process of around three to six months, and that could be too late for the threshold calculation. We would need a solution in Q1 of this year to not have to reduce the activity,” says Horstmann.

Not like CCPs

While UK trading venues including Ice Futures Europe and LME have not yet been added to Esma’s all-important equivalent third-country venue list for Emir, the EC granted UK-based central counterparties (CCPs) time-limited equivalence until June 2022.

Contrasting approaches for clearing and execution venues reflect fundamental differences in access rules. The clearing obligation under Emir requires firms to clear mandated swaps at recognised central counterparties, so no equivalence would have terminated EU firms’ access to UK clearing houses immediately.

“The main concern has always been around CCP equivalence as the moment that goes away, the implications are very severe because market access to UK markets would really be jeopardised for EU end-clients,” says ABN Amro’s Booij. “Many commodity contracts traded on these UK markets do not have an EU alternative, so access to these markets and their relevant CCPs is essential to EU corporates and other investors.”

By contrast, exchange access is governed by national legislation. Ice Futures Europe and LME, which list crucial oil and metals contracts, respectively, secured appropriate licences and exemptions in jurisdictions requiring access to trading systems – for example in Germany and the Netherlands. This avoided access disruption for EU clients.

In addition to allowing continued access for EU firms, temporary recognition of Ice Clear Europe and LME Clear – as well as LCH – ensures these clearing houses retain “qualifying CCP” status under Emir. This means capital requirements on impacted instruments will not increase for EU clients, even though they are now technically designated OTC.

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