The European Commission’s Equivalence Decisions for Third-Country Central Counterparties: Between Financial Stability and Political Considerations

The present chapter analyses the regulation and supervision of Central Counterparties (CCPs) in the European Union. The European Market Infrastructure Regulation (EMIR) establishes a regulatory framework for EU and non-EU CCPs to operate in the Internal Market, offering clearing services to EU clearing members and trading venues. While EU CCPs are subject to EMIR requirements, enforced by national authorities, Third-Country CCPs (TC-CCPs) can access the EU only if the European Commission considers their home regulation to be “equivalent” to EMIR. The chapter is organized as follows. First, it examines the relationship between central clearing and financial stability, outlining the centrality of CCPs for the post-crisis financial system and their nature of “too-big-to-fail” market infrastructures. Second, it analyses the regulatory and supervisory framework for CCPs established in the European Union and third countries. Thereafter, it describes the most recent reform of the framework for TC-CCPs (the EMIR 2.2 regime), where ESMA and the ECB are given enhanced powers to supervise systemically important TC-CCPs. Finally, the chapter concludes by assessing whether the equivalence framework for TC-CCPs can be considered effective from a financial stability perspective. The chapter finds that further improvements would be necessary to fully protect EU financial stability from potential risks.KeywordsCCPsEMIREquivalenceEMIR 2.2ClearingRelocationBrexitLondonCFTCESMA

An understanding of Over-The-Counter (OTC) derivatives – particularly Credit Default Swaps (CDSs) – is essential, because these derivatives are often accused of being toxic and a significant contributor to the financial turmoil of 2008, and therefore also indirectly causing the sickly world economic growth experienced since. This is the position embraced by high-level politicians at G20, in the EU and in the United States; therefore, an overhaul of the OTC derivatives – including the CDS market – appears inevitable. Nonetheless, this article questions this perception of CDSs as an exclusive detrimental product and argues that, although problems of concentration and interconnectedness in the opaque CDS market arguably amplified the crisis, CDSs merely reflected the crash of the US mortgage market. If this is not recognised by politicians and regulators, the likelihood of incomplete reforms causing unintended consequences seems inescapable. This scenario already seems to be playing out in Europe and also potentially in the United States, although an analysis of the US reform is beyond the scope of this article. This conclusion is reached by evaluating three proposals by the European Commission: the European Market Infrastructure Regulation, the Market in Financial Instruments Directive and the Capital Requirement Directive. In short, they intend to mandate or heavily incentivise the trading of CDSs through Central Counterparties (CCPs) and exchanges; enhance OTC-traded CDSs’ capital requirements; and require trades to be reported to designated trade repositories. Although these proposals are well intentioned, the unintended consequences could be considerable, particularly with regard to the extent to which credit risk hedging is possible through CDSs owing to potential prohibitive OTC capital, CCP and exchange-trading requirements. Rather, it is suggested that the reform could be detrimental to its inherent purpose, financial stability, as a concentration of credit risk can accumulate in CDS CCPs. Juxtapose market participants’ ability to hedge credit risk in the regular OTC market is diminished, thus positioning CDSs in a diminishing vacuum between the OTC and exchange traded market. In a worst case scenario, this would undermine the liquidity of the CDS market and make credit risk hedging significantly more difficult and expensive for end-users and ultimately society, at the same time as crucial information on entities creditworthiness deteriorates.

Once seen as the solution to the systemic risk of over-the-counter derivatives, central counterparties (CCPs) have become a source of concern for the financial stability of the European Union (EU). Distress of a single CCP might be transferred to clearing members and others CCPs, thereby endangering EU monetary and fiscal stability. However, the European Market Infrastructure Regulation (EMIR) has left fiscal responsibility as well as day-to-day supervision of EU-based CCPs (EU-CCPs) at the national level, albeit cross-border colleges of authorities can overturn key decisions of national supervisors. The Commission concluded that these supervisory arrangements needed to be reformed because they hamper the development of a single coherent EU approach to CCP supervision. Although the Commission had proposed to centralise EU-CCP supervision in the European Securities and Markets Authority (ESMA), the final 2019 CCP Supervision Regulation seeks to improve EMIR’s ineffective collegial framework by establishing an internal CCP Supervisory Committee within ESMA. Nevertheless, the continuing lack of loss mutualisation would keep on hindering the development of a single approach to EU-CCP supervision. Moreover, the new regulation adds another layer of complexity to the EMIR framework and clashes with the European monetary constitution. If an agreement on loss mutualisation was reached, EU-CCP supervision should be centralised in two EU bodies along objective lines: while the European Central Bank should be tasked with EU-CCP prudential supervision, ESMA should be responsible for EU-CCP conduct of business supervision. This framework would improve EU-CCP supervision and fit in with the current EU governance at once.

This chapter describes the efforts to regulate the over-the-counter (OTC) derivatives sector. The business of clearing OTC derivatives is inherently global. The chapter begins by looking at the earliest efforts to regulate the sector starting in the United States in 1987; global standard setters’ first discussions in 1997; increasing concerns after the Long-Term Capital Management (LTCM) default; the first non-legislative measures of the European Union (EU) in 2006; and the watershed moment in 2008 after the Lehman’s default unleashed the financial crisis, resulting in a strong call from G20 leaders to introduce tighter, global regulation of the sector. It traces the preparation and adoption of the EU’s regulatory response: the European Market Infrastructure Regulation (EMIR). The chapter then discusses the first material amendment to EMIR: the EMIR REFIT Regulation. It also examines probably the most politically contentious revision of EMIR: ‘EMIR 2.2’, which contains the EU’s response to Brexit in particular, and the legislative proposal of December 2022 to strengthen the EU’s strategic autonomy by reducing its dependence on central counterparties (CCPs) in the United Kingdom. Finally, the chapter considers the CCP Recovery and Resolution Regulation.

With a notional amount outstanding of more than USD 500 trillion, the market for OTC derivatives is of vital importance for global financial stability. A growing proportion of these contracts are cleared via central counterparties (CCPs), which means that CCPs are gaining in importance as critical financial market infrastructures. At the same time, there is growing concern that a new too big to fail problem could arise, as the CCP industry is highly concentrated due to economies of scale. From a European perspective, it should be noted that the clearing of euro-denominated OTC derivatives mainly takes place in London, hence outside the EU in the foreseeable future. For some time there has been a controversial discussion as to whether this can remain the case post Brexit. CCPs, which clear a significant proportion of euro OTC derivatives and are systemically relevant from an EU perspective, should be subject to direct supervision by EU authorities and should be established in the EU. This would represent an important building block for a future Capital Markets Union in Europe, as regulatory or supervisory arbitrage in favour of systemically important third-country CCPs could be prevented. In addition, if a systemically relevant CCP handling a considerable portion of the euro OTC derivatives business were to run into serious difficulties, this may impact ECB monetary policy. This applies both to demand for central bank money and to the transmission of monetary policy measures, which can be significantly impaired, particularly in the event that the repo market or payment systems are disrupted. It is therefore essential for the ECB to be closely involved in the supervision of CCPs. Against this background, the draft amendment of EMIR (European Market Infrastructure Regulation) presented on 13 June 2017 is a step in the right direction. In addition, there is an urgent need to introduce a recovery and resolution mechanism for CCPs in the EU to complement the existing single resolution mechanism (SRM) for banks in the eurozone. Only then can the diverse interdependencies between banks and CCPs be adequately taken into account in the recovery and resolution programmes required in a financial crisis.

With a notional amount outstanding of more than USD 500 trillion, the market for OTC derivatives is of vital importance for global financial stability. A growing proportion of these contracts are cleared via central counterparties (CCPs), which means that CCPs are gaining in importance as critical financial market infrastructures. At the same time, there is growing concern that a new too big to fail problem could arise, as the CCP industry is highly concentrated due to economies of scale. From a European perspective, it should be noted that the clearing of euro-denominated OTC derivatives mainly takes place in London, hence outside the EU in the foreseeable future. For some time there has been a controversial discussion as to whether this can remain the case post Brexit. CCPs, which clear a significant proportion of euro OTC derivatives and are systemically relevant from an EU perspective, should be subject to direct supervision by EU authorities and should be established in the EU. This would represent an important building block for a future Capital Markets Union in Europe, as regulatory or supervisory arbitrage in favour of systemically important third- ountry CCPs could be prevented. In addition, if a systemically relevant CCP handling a considerable portion of the euro OTC derivatives business were to run into serious difficulties, this may impact ECB monetary policy. This applies both to demand for central bank money and to the transmission of monetary policy measures, which can be significantly impaired, particularly in the event that the repo market or payment systems are disrupted. It is therefore essential for the ECB to be closely involved in the supervision of CCPs. Against this background, the draft amendment of EMIR (European Market Infrastructure Regulation) presented on 13 June 2017 is a step in the right direction. In addition, there is an urgent need to introduce a recovery and resolution mechanism for CCPs in the EU to complement the existing single resolution mechanism (SRM) for banks in the eurozone. Only then can the diverse interdependencies between banks and CCPs be adequately taken into account in the recovery and resolution programmes required in a financial crisis.

The European Union’s (EU) ambition is to encourage clearing at EU Central Counterparties (CCPs) and with EU clearing members (CMs). This is to reduce reliance on systemic non-EU CCPs, and to build a more attractive and robust EU clearing market. To achieve this, the European Market Infrastructure Regulation (EMIR) 3.0 requires EU CMs and clients subject to the clearing obligation to hold active accounts at EU CCPs. Although it is very unlikely that the watered-down compromise will fulfil the EU’s ambition, more importantly it still risks diminishing the competitive position of EU companies, leading to EU clients who do not fall under the clearing obligation to use non-EU CMs, and directing non-EU clients’ euro-denominated interest rate swaps trading activity towards non-EU dealers. This seems contradictory to the policy objective of building a strong EU Capital Markets Union (CMU). With regard to supervision, EMIR 3.0 is a missed opportunity for a centralised supervisory framework. Just enhancing the current decentralised supervision mechanism, which is based on cooperation and information sharing between National Competent Authorities (NCAs), is not enough. A European centralised supervisor will not only strengthen risk monitoring and (eventually) minimise systemic risks but will also reduce supervision costs, the number of procedures, divergent interpretations of EMIR rules and the exchange of data. Whereas the main focus with regard to EMIR 3.0 was geared towards the active account requirement and whether or not to centralise supervision of EU CCPs, regulators and market participants would be ill advised to let discussions over third-country CCP equivalence issues distract them from other important and persistent challenges in the derivatives clearing markets. There are currently three pressing issues that require attention: clearing access and capital rules, portability and clearing models, as well as liquidity and collateral optimisation. A failure to address them risks undermining the key driver for derivatives clearing, which is increasing financial stability.

As part of financial market infrastructures, central counterparties (CCPs) have long been deemed systemically important and are likely to gain in importance due to the regulatory developments mandating central clearing for an increasing number of financial products. This paper focuses on the regulation as well as the recovery and resolution of CCPs in Europe. The existing CCP regulatory framework consists of ex-ante measures, including, among others, capital and liquidity requirements, initial and variation margins, and loss sharing mechanisms. In addition, the European proposal for the recovery and resolution of CCPs (the Proposal) contains several ex-post regulatory measures mainly in the form of rules for recovery and orderly resolution. Having studied the prudential regulatory measures for CCPs contained in the European Market Infrastructure Regulation and the ex-post recovery and resolution measures of the Proposal, this paper puts a spotlight on the specific shortcomings of the existing and proposed rules, in particular in terms of misaligned incentives, externalities, collective action problems, and certain practical impediments, and concludes that it would be misguided to inordinately rely on ex-post measures. Highlighting the limitations of the recovery and resolution mechanisms, this paper proposes that given the systemic importance of CCP functions, it is critical to improve the ex-ante measures whose objective is to prevent the failure of a CCP, rather than ex-post measures, which kick in after its failure. Accordingly, recommendations for making such improvements are proposed.

In the wake of a series of financial crises occurring between 2007 and 2009, there has been a political consensus, at a global level, on various regulatory reforms after the G20 Pittsburgh Summit 2009. The regulatory reforms were aimed at the shadow banking system (SBS) through an enhanced market transparency and regulation of over-the-counter (OTC) derivatives. These two objectives are not mutually exclusive. From a regulatory standpoint, they are relative. This chapter analyses these two objectives in the contextual framework of the European Market Infrastructure Regulation (EMIR). The analysis focuses on the reporting obligation to the trade repository (TR) and the clearance obligation of designated OTC derivatives through the central counterparty (CCP). The chapter argues that while these two obligations can functionally transform shadow banking into a resilient market-based finance, the regulatory framework also creates an exchange platform that transforms the OTC derivative contracts into the fungible securities. The transformation is manifested in the functional role of the CCP as both the buyer and the seller to all CCP participants. By interposing the CCP in between counterparties, OTC contracts have the same counterparty. The counterparty substitute is achieved by novating their original contracts. The CCP becomes a static counterparty to all OTC derivatives contracts. Consequently, all contracts are novated with same counterparty – the CCP. The substitution and novation transform these contracts into futures contracts or fungible securities. In doing so, the legal process also shifts the bilateral counterparty risk to the CCP. When the CCP takes over the counterparty risk, the risk is reduced through a centralized process of net-off that results in a single net payment or no payment to a participant in the CCP. The role of the CCP also transforms the legal bilateral obligations and rights analogous to multilateral set-off with the resultant recipient of a single net payment. The economic advantage is that in the event of a party's insolvency, the non-faulting party reduces the totality of its claim against the insolvent party. The CCP also deals with the potential systemic instability triggered by the breach of contractual obligation of a financial institution. These coincide with the stability objective in the Markets in Financial Instruments Directive (MiFID) and the Dodd–Frank by bringing derivatives 'on exchange' so as to enhance the transparency of the market. By regulating the OTC contracts from the outset as a securities product, the EMIR facilitates the market participants with a platform that makes the OTC derivatives ready and transferrable as a thing. The private-law technique becomes a tool for 'public regulation' and is justified by the transaction cost analysis for the 'public good', but there is a subtle evolution in the way that law recognizes OTC derivatives as more than just about contractual obligations and rights.

In light of the recent global financial crisis, regulatory attention has been focused on the Janus-headed activity of over-the-counter (OTC) credit derivatives. As a result, heavy-handed measures have been introduced, such as those in the Dodd–Frank Act and the European market infrastructure regulation, which mandate central counterparty clearing for OTC credit derivatives. The deployment of central counterparties (CCPs) is by no means a panacea for global financial stability. Drawing on the ongoing debate about the benefits of CCPs, this paper considers them through the lens of the Legal Theory of Finance proposed by Katharina Pistor. This leads to a number of observations: firstly, CCPs lack sufficient tools to adjust for the materialisation of unexpected circumstances, not least because of precarious state-contingent collateral calls. Moreover, the hierarchy of the financial system highlights a hierarchy with respect to the vindication of property rights in times of crisis. This causes one to consider financial stability as a public good and to argue in favour of stronger social responsibility in financial markets. Major financial players ought to be required to have more ‘skin in the game’. CCPs therefore lend themselves as a focal point for regulatory measures.

This paper examines the common approach reached between Commodities Future Trading Commission (CFTC) and the European Commission (EC) on derivatives regulation. The paper reviews issues resolved and explores the issues that remain which are leading to fragmentation of the $553tn global derivatives market. While many differences have been resolved, it would have been better for the markets had both the European Union [EU] and United States [US] adopted a collaborative approach when reforming derivatives after the Financial Crisis (2008). This decision of the EU and US to proceed separately and draw up their own respective versions of the over the counter [OTC] derivatives regulatory landscape was a misstep which affected the efficient operation of capital markets. The question now is whether co-operation between US and EU regulators can survive the disruption posed by Brexit and the Trump Administration and the new directions the UK and US might take in terms of derivatives regulation. The long-term effect that Brexit may have on the regulation of derivatives will depend on the new post-Brexit relationship that the UK and the EU agree upon. It is essential that the smooth functioning of the international derivatives trading market and the critical role that London plays as the global centre for Euro denominated clearing must continue without regard to whether a political agreement can be reached on the withdrawal of the UK from the EU. A discussion as to the post-Brexit role that the City of London should play in respect of Euro denominated clearing and the services the City performs for EU clearing members and trading venues needs to be had to give the EU the assurance it requires to have oversight over central counterparties (CCPs) operating in third countries (such as post-Brexit UK) that perform systematically important functions for EU clearing members and trading venues. In the US, if the Trump Administration can reform current CFTC regulation to reduce the extraterritorial impact that current US swaps trading rules have on non-US market participants, this could be beneficial to reduce the fragmentation that is occurring in the global swaps trading pool. It is encouraging to see CFTC Chairman Giancarlo propose implementing a two-tier system that would separate foreign jurisdictions into those that are “comparable” and those that are “non-comparable” in order to afford comparable jurisdictions greater control over their own regulatory matters so long as such matters do not pose a risk to the US financial system. However, such a reform will require Congress to act and they will look to what the EU is doing in respect of its European Market Infrastructure Regulation on derivatives, central counterparties and trade repositories (EMIR 2.2) reforms before committing the CFTC to reducing the control it asserts on non-US market participants. The role of European Security and Markets Authority (ESMA) and its plans to introduce EMIR 2.2 at this juncture will play a pivotal role in determining whether the possibility of further reducing the extraterritorial application of derivatives regulation globally will continue.

The obligatory clearing of certain contracts through CCPs, that is imposed by Regulation (EU) no. 648/2012 of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (called “EMIR”, i.e. European Market Infrastructure Regulation), is justified by the need to increase the transparency of the derivatives market, to mitigate systemic risk and to promote stability of the financial system. Central counterparties (CCPs) are clearing houses that interpose themselves between the counterparties to the contracts traded on one or more financial markets, becoming the buyer to every seller and the seller to every buyer. In this way CCPs are responsible for the clearing of transactions concluded on derivatives market, which reduces the credit risk of individual counterparties. The EU legislator creates a legal framework for the functioning of CCPs that become new systemically important institutions. In addition, EMIR leads to the creation of a kind of monopoly as CCPs’ services become compulsory for entities involved in trading on financial instruments that will be subject to central clearing. For these reasons, EMIR represents new and difficult challenges for effective oversight and supervision of financial markets. The tendency to maintain a market structure where operate only a relatively limited number of CCPs is likely to be perpetuated due to the predominance of entities with established market position, as well as the presence of high sunk costs associated with the rigorous regulatory requirements that determine the possibility of entering the market. The regulation of financial market infrastructure has to take into consideration and to integrate two perspectives: micro (transaction costs) and macro (systemic risk).

The European Commission’s Equivalence Decisions for Third-country Central Counterparties: Between Financial Stability and Political Considerations

This chapter assesses the international policy debate on insolvency management in relation to central counterparties (CCPs), as well as the general context in the European regulatory framework for the licensing and ongoing regulation of CCPs. It then turns to a closer examination of the new Regulation, which has been strongly influenced by the Financial Stability Board’s (FSB) ‘Key Attributes of Effective Insolvency Regimes for Financial Institutions’ of 2014, but is far more detailed and prescriptive. While the prudential requirements for CCPs’ own risk mitigation and loss management arrangements established under the European Market Infrastructure Regulation (EMIR) have been taken as the basis for recovery measures, the Regulation introduces some key features of recovery and resolution regimes for banking institutions also in relation to CCPs. Just as banks, CCP operators, under the Regulation, will be required to engage in rigorous recovery planning, while resolution authorities are required, in turn, to develop resolution plans in order to prepare for future contingencies. For the actual resolution stage, the Regulation prescribes a number of statutory tools, some of which have also been adapted from the corresponding regime for failing banks.

This chapter explains central counterparty (CCP) access structures. It describes clearing member types, client clearing models under European and US law, and the relatively new type of direct access models. The chapter does this by illustrating a concrete case study: the (over-the-counter, OTC) access structures of Eurex Clearing AG (Eurex Clearing). Eurex Clearing was authorized as a CCP under the European Market Infrastructure Regulation (EMIR) in 2014 and as a Derivatives Clearing Organization (DCO) for the clearing of swaps in relation to entities located in the United States by the US Commodity Futures Trading Commission (CFTC) in 2016. The in-depth explanation of Eurex Clearing’s access structures is followed by a reflection of their market take-up and related developments. The chapter also draws direct comparisons between OTC patterns and other market structures, such as those existing for Eurex Clearing’s listed derivates and repo markets as well as other CCPs.