Equivalence in European and US clearing rules
The European regulator, ESMA (the European Securities and Markets Authority), has so far deemed the rules and their regulatory outcome around central clearing to be equivalent to its own standards in Japan, Singapore, Australia and Hong Kong, with the frameworks in Canada, Mexico and India expected to follow shortly. The big name missing from this list is the US.
Equivalence is important since it means that European banks clearing their trades via CCPs (central counterparty clearinghouses) in equivalent jurisdictions can do so without the need for added compliance burdens, since their domestic regulator (ESMA) recognises the jurisdiction in which they are trading as being up to an equivalent standard as regards the regulatory framework. For example, a European bank clearing trades at a Japanese CCP can do so within a similarly robust safety framework as it does at an approved European CCP – according to ESMA’s view of the matter at any rate.
European banks and market participants can also clear their trades at CCPs in those equivalent jurisdictions without being subjected to increased capital requirements on their balance sheets to margin the trades. Margin, both initial and variation, is posted at the CCPs to cover potential losses on positions.
Europe has linked its regulatory framework concerning central clearing to the new capital requirements laid out in CRD IV, meant to reflect Basel III in appropriate circumstances. To ‘de-risk’ the system, these requirements greatly encourage banks to put their OTC trades through CCPs, since this is seen as the safest way to operate – central clearing of OTC contracts was one of the 2009 G20 responses to the global financial crisis, with a CCP acting as a buyer to every seller and a seller to every buyer. The implementation of globally harmonised regulatory frameworks around these systemically important infrastructures has not been smooth, with a battle having being fought out over extraterritoriality; the manner in which one jurisdiction can impose its rules upon another. FATCA is an example of this emanating from Washington.
If banks are using Qualified CCPs (QCCPs), those approved by ESMA in Europe, then the banks can subject their trades to a two per cent risk-weighted capital charge. If they are clearing through a CCP that is not recognised by ESMA, then this capital charge leaps up. This is to reflect the greater perceived risk exposure generated via clearing at a non-QCCP. The QCCP title is handed down by a CCPs local regulator, so for the purposes of equivalence with Europe, the regulatory framework in which a CCP operates still needs to be approved by ESMA.
CME Group has publicly estimated that this could result in capital charges as much as 30 times in excess for banks not using QCCPs. It is, therefore, very important for US clearing houses to be recognised in Europe, since if they are not, the cost of clearing at US institutions for European banks could be cripplingly expensive and they will walk away.
The implementation of CRD IV in Europe has already been pushed back twice as a result of this delay in judgement on equivalence, most recently to 15 June 2015. ESMA and its US regulatory equivalent, the CFTC (Commodity Futures Trading Commission) have been discussing the best path to equivalence for two years now, with some hope of it being reached soon.
At the FIA conference in Boca Raton last week, Timothy Massad, chairman of the CFTC, said that his organisation has agreed to a lot of the changes requested by Europe in order to find harmonisation - a partial compromise - although added that they “would not be making significant changes.”
The major point of difference between the two regulators is around margin requirements at CCPs, with Europe having imposed a tougher margining framework than the US. It therefore carries over that they will need to hold increased capital on their balance sheets against trades conducted at non-QCCPs in order to mitigate the failure of that CCP, something deemed to be more likely by ESMA than at those CCPs it recognises.