Brussels: European Commission could intervene if clearing pushes buy-side out of swaps market

LegalOperational RiskPrime BrokerageRegulation
10 Sep, 2012

The European Commission has said it could intervene to ease CCP collateral requirements for buy-side firms trading swaps to prevent them  being priced out of the market.

Regulators could intervene if clearing costs become too much for some buy-side firms

“Necessary action will be taken if competition issues do arise and firms are priced out of the market because of clearing, and regulators will intervene to take steps against this. We will not exempt these impacted firms from clearing altogether because that would a risky way out but one possibility for the market could be a differentiation in the clearing collateral that they post,” said Patrick Pearson, head of financial markets infrastructure at the European Commission, speaking in Brussels.

Pearson said he would be monitoring the situation closely with the Directorate General for Competition at the European Commission.

Expanding the scope of eligible collateral would ease pressure on the buy-side. Many buy-side firms do not have the high-grade collateral demanded by CCPs at hand, and are likely to be forced to go to their prime brokers for collateral transformation upgrades. A collateral transformation upgrade is when previously ineligible collateral is turned into eligible collateral – this again is not cheap.

“The European Central Bank (ECB) has said that certain loans to some corporates could be used as eligible collateral for the banking regulation's liquidity ratio. Does it not make sense for CCPs to refuse to accept such assets as collateral?” commented Pearson.  Were the criteria for eligible collateral expanded, it would also mitigate the risk of a collateral squeeze. “A collateral squeeze is a big issue because everybody wants collateral. Collateral is a finite resource and this is also something we are carefully monitoring,” he added.

Nevertheless, CCPs were warned that competition on margin would be an unwelcome development. One unnamed CCP was reported to have reduced its margin requirements by 60% in 2011 which Pearson at the time made abundantly clear was unacceptable. He now believes concerns over CCPs competing on margin have been reduced. “While there are still concerns about CCPs competing on margin, we shall have regulatory standards in place on margin by the end of the year which will clearly identify the risk management criteria we expect. It will therefore be less of an issue,” said Pearson.

Numerous buy-side firms have long complained about the ongoing regulatory uncertainty surrounding swaps clearing. Some have even put off their preparations as deadlines have been repeatedly pushed back. The lack of clarity on the final rules has prompted some buy-side firms to delay finding a clearing broker or negotiate their intricately detailed clearing agreements.

This inaction was rejected as unacceptable by Pearson. “Buy-side firms have had three years to prepare for these rules and they have known for three years these reforms would happen and that they would be implemented from January 1, 2013. That date has never changed. The rules in both the US and EU are 95% complete although some details do remain. There are 100s of pages of readily available documents in the US outlining the rules, and 100s of pages contained in the EU draft rules. ESMA published a technical consultation in the summer so there should be very little uncertainty about this,” he said.

Nevertheless, Pearson acknowledged cross-border issues still needed to be hammered out although added regulators globally - along with politicians - were working to reach a solution.

CCP failure also registers highly among buy-side firms. CCPs are not immune to failure. Clearing houses in Malaysia and France defaulted in the 1970s. Most worryingly of all, the Hong Kong Futures Exchange had to be rescued by the government in 1987. “We have worked hard to mitigate CCP failure. Firstly, CCPs will have CPS IOSCO G10 standards so will be adequately risk managed. If a CCP does run into a stress situation, we are working with the Financial Stability Board on safeguards to give the CCP access to liquidity,” he said.

Were a CCP default imminent, the protections are less clear-cut due to the different rules and CCP structures across multiple jurisdictions. “It depends on the CCP structure and the regulations in the affected market. But were a CCP to require a lender of last resort, either a Central Bank or the market itself could be that lender,” commented Pearson.

CCPscollateralcollateral squeezeEuropean Central BankEuropean Commission