US dealers wade into European CCP relocation debate

CFTC hearing warns of increased margining costs and a pre-Brexit client onboarding crunch

All at sea: dealers might have to split trading and client coverage across two entities

US market participants are stepping up their criticism of European plans to tighten the supervision of clearing in euro-denominated swaps, following a legislative proposal by the European Commission earlier in June that would give the European Central Bank greater decision-making powers on the location of central counterparties (CCPs).

A hearing of the Commodity Futures Trading Commission (CFTC) market risk advisory committee on June 21 was the venue for a litany of complaints about the proposal, and especially its impact if CCPs are forced to relocate the euro-denominated part of their activities from London to countries in the EU27 after Brexit.

“One of the key benefits of central clearing is risk exposure reduction through multilateral netting and portfolio margining,” Marnie Rosenberg, global head of clearing house risk and strategy at JP Morgan, told the hearing. “Loss of netting and trade compression could lead to larger aggregate exposures to CCPs across the market and less efficient risk management. It could lead to additional margin requirements as portfolios are split. This means initial margin, default funds posted at multiple CCPs, potential assessment calls and liquidity demands all go up – and not by choice of participants.”

The main UK clearing house, LCH, is engaged in a war of numbers with Germany’s Eurex about the wider market implications of the EC’s proposal, and US players are clearly siding with LCH.

Susan O’Flynn, global head of CCP strategy, governance and optimisation at Morgan Stanley, told the hearing Brexit would already create challenges for derivatives market participants, even without CCP relocation. Faced with uncertainty about what the terms of Brexit will be, O’Flynn said Morgan Stanley’s UK broker-dealer business is preparing for the possibility that it will find its access to European clients limited, as it would no longer benefit from passporting rights. Banks will have to establish a new entity based in the EU27 or relocate certain activity to existing European entities in order to transact with European clients.

“This entity may require new exchange and clearing memberships in order to ensure continuity of activity,” said O’Flynn. “A key dependency here is exchange and CCP onboarding capacity in a shortened timeframe, due to the large expected influx of dealers looking to be ready to trade well in advance of the March 2019 [Brexit] date. Significant resources will also be required internally to build out our market structure partners.”

The operational challenges will be even greater if the UK CCPs are forced to move some of their clearing services to the EU27 at the same time as the restructuring of non-EU dealers.

Straddling entities

“Dealers will have split trading and client coverage across two entities. Split risk and trading across entities will lead to increased cost for dealers, both from a margin and supplementary leverage ratio capital perspective, at the outset,” warned O’Flynn. “This will be optimised over the longer term. Execution pricing may be adjusted to absorb these costs [and] that may impact all market participants. This planning becomes much more complex if the equivalence of UK CCPs is not retained, or if the relocation of euro clearing were to occur – most notably for interest rate swaps.”

Rosenberg said it will not be known for some time if LCH or other UK-based CCPs are deemed systemically significant enough to be denied third-country recognition under the EC’s new proposals. She suggested there were easier ways to tackle the challenge that would be less disruptive for the market, for instance by focusing on supervisory co-operation.

“We do believe the challenges associated with the growing systemic importance of CCPs and the impact of Brexit can be effectively addressed through enhancements to oversight and recognition without requiring CCPs to relocate,” she said.

This is similar to the stance taken by Steven Maijoor, chairman of the European Securities and Markets Authority (Esma), who has so far stopped short of calling for outright relocation.

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