New Brexit carve-out urged for legacy EU cleared swaps

Risk and default management of grandfathered portfolios required in any clearing relocation plan

Knock-on effects: grandfathering legacy portfolios is not enough to smooth the impact of Brexit on clearing

Grandfathering existing portfolios of cleared swaps from proposed European Union rules that may force the relocation of clearing houses away from London after Brexit would not be enough to ensure a smooth transition, market participants are warning.

The European Commission (EC) has proposed an amendment to the European Market Infrastructure Regulation that could see third-country central counterparties, which handle very high volumes of trades for EU firms, forced to relocate those operations to the EU27. This move, intended to ensure adequate supervision of clearing by the EU authorities, would primarily affect LCH in London, which is the main clearing house for European interest rate swaps.

“If UK CCPs cannot be used post-exit day to meet the Emir mandatory clearing obligation because they are not recognised under Emir, what is the impact on firms’ legacy portfolios? Would EU27 firms still be permitted in practice to risk-manage down their positions at UK CCPs post-exit day, either by compressing them or closing them out, notwithstanding the prohibition under Emir from using non-recognised CCPs to clear new trades?” asks Simon Puleston Jones, head of Europe at the Futures Industry Association.

A leaked position paper, produced by the Council of the European Union in October, suggested a more nuanced approach, whereby existing derivatives trades could be protected to take account of “the consequences of including the outstanding cleared transactions within the scope of the implementing act”.

Yet, even if the EC mandated that only new trades involving European counterparties would be required to shift to an EU27 CCP post-Brexit, legacy portfolios could not simply be left at LCH to roll off over time. Clearing members would need the ability to manage those portfolios, which could include entering into new trades.

A head of clearing at a London-based Tier 1 bank says: “One of the things proposed for mitigating the impact of having to move clearing is to grandfather legacy portfolios, so clearing firms can leave existing portfolios in LCH and move new trade volumes over to a new CCP in time. But that gives us two knock-on issues that are more challenging.”

First, new trades would be required to risk-manage legacy portfolios in London as portfolio risks change over time. Citing the example of two curve trades – one long in five-year and another short in 10-year – the head of clearing says in five years’ time these would become an outright position in a five-year maturity: “So we would need some way to put new trades into that portfolio to manage the ongoing risk.”

If banks can’t participate in the default management process then the CCP may decide, for good risk management reasons, that those banks cannot be a member

A clearing house source

Secondly, it is a membership criterion for swaps at LCH that a member shows evidence that it is able to participate in the default management process by being able to bid for the portfolio of a defaulting member.

A clearing house source says: “It would be difficult for a CCP to keep members on the basis that it only looked after their legacy positions. If banks can’t participate in the default management process then the CCP may decide, for good risk management reasons, that those banks cannot be a member any more and then it effectively becomes a forced unwind of their entire book.

In September, Patrick Pearson, head of financial markets infrastructure at the EC, suggested not every aspect of clearing activity would need to be relocated: “Are we talking about moving the entire book? Are we talking about certain clearing services, certain products? Are we looking at requiring the entire stock or only the flow? Are there going to be maturity criteria that will be applied in any decision from the commission?”

But the clearing house source warns separating stock and flow in this way might not be practical from a default management viewpoint: “On swaps, if one CCP had the stock and another CCP had the flow, it’s difficult to see how the CCP that’s only got the stock can confidently risk-manage that stock in a default, because the way you unwind the defaulted position is by having access to the kind of deep liquidity that you would get by being the main clearing house of the flow.”

Systemically destabilising

A land-locked grandfathered portfolio in a CCP with no flow undermines the clearing proposition and would be potentially “systemically destabilising”, adds the source.

Another head of clearing at a US-based Tier 1 bank agrees, saying: “How do you conduct default management if you can’t execute euro-denominated macro hedges? I guess you’d have to restrict your macro-hedge pool to just US persons or something if European banks couldn’t trade. It would hamper your ability to macro hedge.”

Puleston Jones called for clarification on this issue at a hearing in the UK Parliament’s House of Lords EU financial affairs sub-committee in October. He asked: “Would EU27 clearing members of UK CCPs be declared in default by those CCPs, on the basis that Emir bans non-recognised third-country CCPs from having EU clearing members?”

The EC could choose to avert this situation by allowing EU27 firms a carve-out; to put new trades into a legacy portfolio to manage risk and to participate in default management. The EC did not respond to a request for comment by press time.