By Philip Stafford
Eleven months on and last summer’s accord between the EU and US over jointly overseeing the derivatives market across the north Atlantic is being severely tested. The heads of both the Commodity Futures Trading Commission and the European Commission have both regularly committed to last July’s “Common Path Forward”. But as new CFTC chairman Timothy Massad meets his European counterpart Michel Barnier this week, it is clear that if the relationship has not hit a rough patch, both sides still have a lot more talking to do.
For so long discussions have centred around definitions of “US person” in the Dodd-Frank Act but now that is being replaced by a new issue: European authorities’ recognition of US clearing houses. The touchstone stems from Article 25 of the European Market Infrastructure Regulation (Emir), which allows European banks to use authorised clearing houses outside the EU.
For the overseas clearing house, authorisation depends on two factors: recognition by the European Securities and Markets Authority (Esma) and recognition by the commission that the clearing house’s foreign jurisdiction is equivalent. No fewer than 35 clearing houses from around the world have applied for recognition, and the deadline has been pushed back to December 15.
Here it gets further complicated. Europe has tied its clearing rules to new rules around banking capital ratios, giving people tremendous incentives for using them but also making the standards tougher than anywhere else in the world. Key to the incentive system is that banks using qualified clearing houses may subject their trades to a 2 per cent risk-weighted capital charge. This jumps to as much as 50 per cent if the EU doesn’t recognise the clearing house. The CME reckons that could amount to capital charges in excess of 30 times current levels for some deals. For the big derivatives dealers, it would add up to millions of dollars of savings daily in the amount of collateral they are required to put up.
The problem is that any bank with dollar swap interest rate exposure hedges it with eurodollar contracts in Chicago. Technically, investors can now trade eurodollars in London via ICE Clear Europe, but the bulk of business is in the US. As the head of clearing at one European bank puts it: “You can’t clear eurodollar futures anywhere but the CME.” Consequently there are a lot of nervous European banks. Nor would it be just those with large US exposure, such as Barclays and Deutsche, that would suffer. The CME is equally aware of what it could lose. “There could be “unfortunate consequences” if it wasn’t recognised. “[Some of our members] face a big capital cliff,” warned Kim Taylor, head of CME Clearing last week.
The problem is Europe’s capital requirements also come into effect on December 15. This is creating an almighty squeeze since Esma can only make its decision after the commission has made its ruling. The regulator could theoretically push its decision into the new year, but Ms Taylor cautioned: “Nobody can take a 30-times capital hit, even for 60 days.” That indicated a real need to recognise EU and US jurisdictions as equivalent. But there are clear differences between the two. For example in futures trading, Europe requires two days of margin to be posted, while the US rules requires only one. Europe is tougher on swaps margins.
The suggestion last week by Ananda Radhakrishnan, director of the clearing and risk division at the CFTC, that clearing houses pull back to their own jurisdictions caused consternation with delegates at IDX, not least because it spoke to their worst fears of a Balkanised market.
Privately, some fear the regulatory stand-off is a subtle battle to tip the table in favour of European business interests, which opens up a series of tantalising questions. Could non-recognition of the US bring into existence a highly-liquid European-based eurodollar futures contract, potentially creating the first chink in the CME fortress? Should IntercontinentalExchange and LCH.Clearnet be disadvantaged when they have built successful European businesses? Is this an attempt to lever the CFTC to cede protection of non-US customer products that are US-domiciled?
It is Europe that has the biggest decisions to make in the coming months, if not weeks. Either it sticks to Emir and potentially disadvantages local banks to the benefit of larger US ones. It also opens Europe to the charge that it is exporting its own broad rules around the world. Or it allows equivalence when there will be clear differences in standards.
A compromise may yet be found if overseas clearing houses can persuade the European Commission these alternative standards to risk management do not weaken the financial system. After all, what if the EU’s carefully crafted regulations turn out to have serious miscalculations? Mr Massad and Mr Barnier have much to discuss.
