Smoot and Hawley are alive and well and living in Brussels
The European Union (EU) was founded on the principle of free trade. In practice, however, it has preferred to confine free trade to its own members, and even among them a wide variety of informal barriers have persisted. In its approach to the re-regulation of financial markets since the acute phase of the great financial crisis in 2008, the EU has gradually developed a set of extra-territorial ambitions which are likely to prove every bit as effective as formal tariff barriers in deterring capital inflows and trading activity from elsewhere.
The week before Christmas the protectionist agenda advanced a little further. On 18 December, the Lithuanian presidency of the EU reached a little-noticed but important political agreement with the European Parliament on the CSD Regulation (CSD-R). Diligent readers will remember that this is the instrument which introduces a settlement timetable of trade date plus two days (T+2) throughout Europe in 2015, with costly mandatory buy-ins imposed on any counterparty which fails to deliver securities to meet their side of the bargain.
Giving fund managers and their broker-dealers less time to settle trades, and penalising them if they do not invest enough to speed the process up, is bad enough. But the CSD-R also makes it clear that the EU is an open market for European CSDs only. The Regulation allows any European CSD to offer its services in any EU country, but insists CSDs from countries based outside the EU must register with the European regulator - the European Securities and Markets Authority (ESMA) – if they want to offer their services within the EU.
Worse, non-European CSDs will have to apply to ESMA for authorisation even if they are doing business remotely with a European CSD. As it happens, a variety of non-European CSDs and the ICSDs (Clearstream and Euroclear) have formal links with European CSDs to facilitate transactions between their domestic users and their European counterparties. Chief among them are the Depository Trust and Clearing Corporation (DTCC) of the United States, the Canadian CDS and STRATE of South Africa.
Forcing the extra-European parties to these links to seek formal authorisation from the regulator has a direct parallel in the registration requirement imposed on central counterparty clearing houses (CCPs) based outside the EU via the European Market Infrastructure Regulation (EMIR) that introduces the mandatory clearing and reporting of swaps. In the same regulatory mood as that measure (see http://cooconnect.com/news/extra-territorial-research-european-otc-derivative-regulation-will-drive-costs), the CSD-R will grant remote access only to those CSDs whose regulatory regime ESMA considers equivalent to its own.
In theory, the requirement means that a New York-based prime broker currently settling trades in Eurobonds on behalf of clients via the link between the DTCC and Euroclear Brussels, or FTSE-100 equity trades in London via the DTCC link with Euroclear United Kingdom, will have to stop doing that unless ESMA agrees that the DTCC is entitled to do the job. A laborious and uncertain process of approval of the regulatory regimes of non-European CSDs is now in prospect. Last year, for example, ESMA did not agree that the United States had an adequate regulatory regime in place for its CCPs to compete openly in the European marketplace.
True, the volume of settlement traffic passing through such links is not high. But if CSD-R is implemented as currently drafted, it will impose additional burdens on non-European depositories that transact business with European CSDs. Increased compliance burdens translate into increased transaction costs, either directly, or by means of the work-arounds that have to be devised. Coupled with ESMA reserving the right to exclude foreign competitors altogether, the prospects of competition and innovation in European financial market infrastructure are dimming. None of us should be shy of calling this policy what it is. Extra-territoriality is a cant term for protectionism. Nor should non-European fund managers and investors be blamed for drawing the obvious conclusion: that they are not welcome in Europe.
It is an outcome which serves the interest of nobody. As the great John Morley observed in his imperishable biography of Richard Cobden, “nobody has fully grasped the bearings of Free Trade, who does not realise what the international aspect of every commercial transaction amounts to; how the conditions of production and exchange in any one country affect, both actually and potentially, the corresponding conditions in every other country. It is not Free Trade between any two countries that is the true aim; but to remove obstacles in the way of the stream of freely exchanging commodities, that ought, like the Oceanus of primitive geography, to encircle the whole habitable world. In this circulating system every tariff is an obstruction, and the free circulation of commodities is in the long run as much impeded by an obstruction at one frontier as at another.”