Legally and politically important
(a), (c) and (d): Not cleared from scrutiny; further information requested; drawn to the attention of the Exiting the EU Committee and the Treasury Committee;
(a) Proposal for a Regulation on the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories; (b) Communication from the Commission: Responding to challenges for critical financial market infrastructures and further developing the Capital Markets Union; (c) Proposal for a Regulation on the procedures and authorities involved for the authorisation of CCPs and requirements for the recognition of third-country CCPs; (d) Recommendation on Article 22 of the Statute of the European System of Central Banks and of the European Central Bank
(a) and (c): Article 114 TFEU; ordinary legislative procedure; QMV; (b)—; (d) Article 129(3) TFEU; ordinary legislative procedure; QMV
(a) (38703), 8890/17 + ADDs 1–3, COM(17) 208; (b) (38724), 8873/17, COM(17) 225; (c) (38840), 10363/17 + ADDs 1–3, COM(17) 331; (d) (38883), 10850/17
20.1Over-the-counter (OTC) derivatives, such as interest rate swaps, play an important role in providing liquidity for the economy. However, the 2008 financial crisis also exposed the major risks that the OTC market posed to financial stability. The lack of transparency of the trade in derivatives masked unsustainable exposures of major market participants, which ultimately led to the collapse of both Lehman Brothers and AIG.
20.2In response, the EU adopted the 2012 European Markets Infrastructure Regulation (EMIR). This requires most OTC transactions, to which at least one party is EU-based, to be cleared through a central counterparty (CCP) either authorised by an EU Member State, or based in a non-EU country whose regulatory regime has been deemed “equivalent” to EMIR by the European Commission. Such CCPs must operate under strict prudential and organisational requirements. This process of clearing insulates both buyer and seller from the risk that the other counterparty will default. The UK’s clearing industry plays a leading role in this EU-wide, clearing 75 per cent of all euro-denominated interest rate derivatives (the largest single category of OTC derivatives).
20.3The European Commission conducted a “regulatory fitness” check of EMIR in 2015. While concluding that the Regulation had industry support and was broadly effective, it also saw the need for a number of amendments to make EMIR more efficient. In May 2017, it tabled a legislative proposal (called “EMIR REFIT”) to streamline the clearing and reporting obligations, in particular with respect to the administrative burden imposed on small financial and non-financial counterparties (SFCs and NFCs). The proposal also extends the exemption from the clearing obligation for pension funds amid concerns that, otherwise, EMIR could negatively affect the retirement income they can make available to their customers (see “Background” for more information).
20.4In June, the Economic Secretary to the Treasury (Stephen Barclay) welcomed the proposal, but said the Government would seek to ensure that EMIR remains consistent with the internationally-agreed standards on central counterparties. He further clarified the Government’s position on certain elements of the proposal, including the thresholds triggering the clearing obligation for financial and non-financial counterparties and the classification of securitisation special purpose entities, in a letter dated 24 August 2017. In this letter, he also calls for a “transitional mechanism to minimise disruption and avoid cliff edges” in the provision of clearing services between the UK and the EU once the UK becomes a “third country” vis-à-vis the latter, without assessing the scale of the disruption that might take place—especially in relation to uncleared contracts—if such a mechanism is not agreed.
20.5However, further legislative changes are also afoot as a direct consequence of Brexit. Both the European Commission and the European Central Bank have expressed concerns about the volume of euro-denominated derivatives that are currently cleared by CCPs which, after Brexit, will be regulated domestically in the UK and not be directly subject to EMIR.
20.6To ensure the EU retains oversight of non-EU CCPs which are crucial to the EU economy, the Commission therefore proposed a further set of amendments to the Regulation in July 2017 (called EMIR II). It would, inter alia, create a new category of “tier II” non-EU CCPs under the equivalence regime. This category would be reserved for systematically important third country clearinghouses, which would be subject to an additional set of regulatory requirements if they wish to perform a clearing function under EMIR. It would also allow the Commission to demand that those tier II CCPs which clear the largest amounts of derivatives denominated in an EU currency re-establish themselves in an EU Member State, or lose their status under EMIR. If they refused to relocate, they would be prevented from performing a clearing function for EU-based counterparties.
20.7Separately, the European Central Bank also asked for new regulatory powers over the clearing industry. If the Bank’s Statute is amended in line with its request, it could use those new powers to revive a failed 2011 attempt to force large CCPs which clear substantial amounts of euro-denominated derivatives to relocate to the Eurozone (see paragraphs 20.46 to 20.54 for more information). This would particularly affect UK-based clearing houses. The interaction between the Commission proposal on third-country CCPs and the ECB’s request to regulate clearing services is unclear, but it appears the powers to require relocation would be cumulative.
20.8The Economic Secretary, in his Explanatory Memorandum on the European Commission’s EMIR II proposal, categorically rejected the amendments relating to the location requirement for non-EU CCPs. He said it would “risk fragmenting global derivatives markets”, which in turn would “increase the cost of trading and clearing, acting as a drag on growth and could discourage firms from hedging their risks using derivatives markets”. We do not know if this view is shared by other EU Member States. With respect to the proposal on the powers of the ECB, the Minister noted only that “the Government will carefully consider (…) any interactions between the ECB’s recommendation and the recent Commission proposal to enhance the supervision of EU and third country CCPs”.
20.9However, irrespective of any further steps to restrict the activities of non-EU CCPs in the EU after Brexit, EMIR as it stands will already end the automatic right of UK-based CCPs to perform a clearing function within the Single Market once the EU Treaties cease to apply. Their authorisation by the Bank of England will no longer be valid in the EU-27. This is a logical consequence of the Government’s intention to leave the Single Market and become a “third country” vis-à-vis the EU (which, according to the Chancellor, will take place in March 2019). However, it is unclear how this timetable for a departure from the Single Market is compatible with the Prime Minister’s call for a post-Brexit “implementation period”, during which EU law would continue to apply even though the UK would not be a Member State.
20.10EMIR is a crucial component of the EU’s post-crisis financial regulatory architecture. We have taken note of the Government’s support for the EMIR REFIT proposal to streamline the clearing and reporting obligation for OTC counterparties, and the clarification of its position on reducing EMIR’s burden on SFCs and NFCs. We support this approach, and ask the Minister to keep us informed of developments on this file as deliberations in the Council and the European Parliament progress.
20.11Our primary concern with respect to EMIR and the proposed amendments relates to the status of UK-based CCPs after Brexit. We agree with the Minister that the EMIR II and ECB proposals on the regulation of CCPs potentially raise substantial difficulties. Under the Commission’s proposal it could become significantly more difficult for UK CCPs to obtain individual recognition by ESMA under EMIR. Moreover, the powers of relocation sought by both the Commission and the ECB appear to go beyond what is necessary to ensure third country CCPs do not pose a risk to the EU’s financial stability. It is unclear whether the UK has sufficient support within the Council to counteract these proposals.
20.12We reiterate, however, that if the UK’s becomes a “third country” vis-à-vis the EU come March 2019, EMIR will automatically prevent UK-based CCPs from continuing to operate in the Single Market until they obtain permission to do so from ESMA. In the absence of an interim arrangement which takes effect on “Brexit Day”, there would be severe disruption to the market in OTC derivatives and thus to the European economy more broadly.
20.13In light of the above, we ask the Minister to answer the following questions with respect to the substance of the Commission and ECB proposals:
20.14Following Brexit, the amendments put forward to EMIR could clearly complicate the substantial share of the EU’s trade in derivatives centred on UK-based clearinghouses. It is right that the Government will use the Council’s consideration of the proposals to address legitimate concerns about the potential fragmentation of European capital markets if the new, highly restrictive, requirements for non-EU CCPs are adopted.
20.15However, we are concerned that the Government has been reluctant to acknowledge that, following our withdrawal from the Single Market, UK CCPs will automatically face the regulatory barriers that EMIR already imposes on non-EU clearinghouses. These are not new barriers, but simply those that current EU law—with the UK’s support—requires in relation to non-EU operators.
20.16Once the UK becomes a “third country” vis-à-vis the Single Market, which the Chancellor states will happen on 30 March 2019, British clearinghouses will no longer be authorised by an EU Member State. As a consequence, overnight they would lose their ability to perform a clearing function under EMIR unless, and until, they are recognised by ESMA under the equivalence regime (which, in normal circumstances, could take several years).
20.17Although the Minister appears to recognise this risk by referring to the need for a “transitional mechanism to minimise disruption and avoid cliff edges” in March 2019, it is unclear to us how this can be compatible with a desire to leave the Single Market at the same time. The effect of an abrupt departure of the UK from the EU’s EMIR framework would undoubtedly be hugely disruptive for both sides. Unfortunately, the Minister does not provide any detail on how the interim arrangement would work in practice. We urgently require more details, in particular with respect to the compatibility between the claim the UK will be a third country at the end of the Article 50 period and the Government’s desire to avoid a “cliff edge” change to the terms of the UK’s access to the Single Market.
20.18It is clear, in any event, that the use of a transitional mechanism alone does not solve the issues created by the UK leaving the Single Market. As we have described above, once the UK becomes a third country (whether in March 2019 or at the end of a subsequent transitional period), EMIR’s provisions on restricting British CCPs from performing a clearing function in the EU will automatically apply. We therefore welcome the Minister’s ambition for “heightened supervision, deep cooperation and clear coordination” as a way for the EU and the UK to jointly address the risks of clearing post-Brexit, rather than potential forced relocation of services currently provided by UK firms to the EU or reliance on EMIR’s equivalence regime (see paragraphs 0.37 to 0.45 below). However, as with the transitional mechanism, the Minister has not provided any meaningful description of the means of delivery for this ambition.
20.19In light of the above, we therefore ask the Minister to clarify the following:
20.20We retain all three legislative proposals under scrutiny while legislative negotiations are underway in the Council and the European Parliament. We are content to clear the Commission’s policy paper accompanying EMIR II (document (b)) from scrutiny. We draw these documents to the attention of the Treasury Committee and, in view of the specific proposals targeting British CCPs post-Brexit, the Exiting the EU Committee.
20.21The Committee will consider in due course to what extent the Government’s request for an interim mechanism to maintain current levels of market access between the UK and the EU may require a continued form of EU scrutiny by Parliament post-Brexit.
(a) Proposal to amend Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories: (38703), + ADDs 1–3, COM(17) 208; (b) Communication from the Commission: Responding to challenges for critical financial market infrastructures and further developing the Capital Markets Union: (38724), , COM(17) 225; (c) Proposal to amend Regulation (EU) No 1095/2010 establishing a European Supervisory Authority (European Securities and Markets Authority) and amending Regulation (EU) No 648/2012 as regards the procedures and authorities involved for the authorisation of CCPs and requirements for the recognition of third-country CCPs: (38840), + ADDs 1–3, COM(17) 331; (d) Recommendation for a Decision of the European Parliament and of the Council amending Article 22 of the Statute of the European System of Central Banks and of the European Central Bank: (38883), ,—.
20.22An over-the-counter (OTC) derivative is privately negotiated, and not traded on an exchange. They account for almost 95% of the derivatives market. The size of the market is enormous: in the second half of 2016, the notional outstanding amount of OTC derivatives was nearly $483 trillion (£367 trillion). However, the financial crisis highlighted deficiencies within the market, with major implications for financial stability. The first deficiency was counterparty credit risk: the default of a major participant in the OTC market can have systemic implications, requiring Government intervention. The second was transparency, as neither market participants nor regulators had sufficient oversight of exposures in the OTC market, causing unwillingness to trade in stressed markets and restricting liquidity.
20.23To address these issues, in 2009 G20 leaders agreed the Pittsburgh Declaration. It stipulated that all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms and cleared through central counterparties, by the end of 2012 at the latest. They also called for use of non-centrally cleared contracts to be discouraged by making them subject to higher capital requirements. Leaders also agreed that all OTC derivative contracts should be reported to trade repositories.
20.24In response to this G20 agreement, the EU adopted the European Market Infrastructure Regulation (commonly referred to as EMIR) in 2012. EMIR ensures that information on all EU derivative transactions is reported to a recognised trade repository (the “reporting obligation”). This data is made accessible to supervisory authorities, including the European Securities and Markets Authority (ESMA), to give policy makers and supervisors a clear overview of activity in financial markets.
20.25The second central requirement is for standard derivative contracts to be cleared through CCPs (the “clearing obligation”). This process of clearing insulates both the buyer and seller of a derivative from the risk that the other counterparty will default, concentrating the risk in the CCP. It also establishes stringent organisational, business conduct and prudential requirements for CCPs. EMIR ensures that counterparties to an OTC derivatives contract exchange margin (collateral) for trades that are not cleared through CCPs, making it more expensive.
20.26The UK plays a central role in clearing derivatives globally, as well as in the implementation of EMIR for the EU and the Eurozone. The Bank for International Settlements has stated that the UK is the single largest venue for OTC derivatives activity. Globally, UK-based CCPs account for almost half of all clearing of interest rate derivatives (which account for 80 per cent of all OTC transactions). For euro-denominated interest rate derivatives the UK is an even larger centre, clearing 75 per cent of all such transactions. There are four UK-based CCPs recognised under EMIR.
20.27In November 2016, the Commission published a report of its review of the application of EMIR, as part of its “regulatory fitness” (REFIT) process of evaluating EU legislation. It concluded that there was general support for the core objectives of EMIR of promoting transparency and standardisation in derivatives markets and reducing systemic risk through its core requirements. It also proposed a new legislative framework for the recovery and resolution of CCPs at risk of collapse, aiming to clarify lines of responsibility and measures to mitigate any spill-over effects in the “unlikely situation” that an EU-based central counterparty had insufficient liquidity to meet its obligations. We have considered this proposal elsewhere.
20.28In addition, the Commission identified a number of areas where EMIR could be adjusted, in order to increase the efficiency of its requirements and reduce “disproportionate costs and burdens” on businesses. It said that it was considering a number of amendments to EMIR with respect to the obligations for counterparties. On 4 May 2017, the Commission tabled a legislative proposal (document (a)) to amend EMIR in line with the priorities identified in its November 2016 report. The proposal, colloquially referred to as “EMIR REFIT”, focuses on the obligations of the counterparties to a derivatives transaction.
20.29Also in May 2017, the Commission published a further policy paper on EMIR entitled “Responding to challenges for critical financial market infrastructures” (document (b)). The paper outlined further changes to EMIR relating to the regulation of central counterparties. It envisaged the introduction of a more centralised system of oversight for EU-based CCPs (at the expense of each clearing house’s national regulator), and changes to the system of supervision of systemically important CCPs based outside of the EU. The Commission explicitly linked the need for legislative amendment in this latter area to the UK’s withdrawal from the EU. The legislative proposal to give effect to these changes, known in Brussels as “EMIR 3rd countries”, was published in June 2017 (document (c)).
20.30Separately, in July 2017, the European Central Bank published a Recommendation (document (d)), asking for the power to regulate clearing and payment systems in the Eurozone.
20.31The remainder of this Report focusses on the three legislative proposals contained in documents (a), (c) and (d).
20.32In May 2017, the Commission published its first proposed amendment to EMIR. The primary objectives of the proposal are to:
20.33Stephen Barclay, the Economic Secretary to the Treasury, submitted an Explanatory Memorandum on document (a) on 3 July. In it, he noted that the Government supports the Commission proposal, but would use its examination by the Council to ensure that EMIR would remain consistent with the implementation of the 2009 Pittsburgh agreement across G20 partners, and that application of the Regulation between EU Member States would not lead to regulatory arbitrage and competitive distortions.
20.34With respect to the timetable for implementation of the REFIT proposal in the context of the UK’s withdrawal from the EU, the Minister has stated that the Presidency and the Commission are seeking “swift agreement on the proposal so that certain provisions come into force by summer 2018”.
20.35The Commission’s second proposal to amend EMIR (document (c), which we will call EMIR II) focusses on the authorisation and supervision of clearing houses, and in particular the role of the European Securities & Markets Authority (ESMA) and Central Banks in overseeing CCPs both established in and outside the EU. The Commission argues that a more centralised system of oversight is necessary because “central clearing has been significantly expanding and CCPs have become increasingly concentrated and integrated across the EU and with third countries”, making it harder for national regulators to maintain adequate oversight.
20.36For CCPs established in the EU, the Commission has proposed to introduce new supervisory powers for the European Securities & Markets Authority (ESMA) and the “Central Bank of Issue” or CBI (i.e. the Central Bank which issued the currency of the OTC transaction, which would usually be the European Central Bank). While national authorities would keep their existing supervisory powers, the proposal would:
20.37The second element of the June 2017 amendment to EMIR relates to the supervision of non-EU CCPs. The role played by CCPs in protecting the European economy from financial instability has meant that who regulates clearing houses, and by extension where they are located, continues to be politically contentious.
20.38Under the current provisions of EMIR, CCPs based outside the EU can seek recognition from ESMA. If granted, EU-based counterparties can use these non-EU entities to fulfil their clearing obligation. However, ESMA can only grant non-EU organisations recognition after the European Commission has adopted an “equivalence decision”. This is a legal determination that the country where the CCP is based has the same level of regulation as provided by EMIR. The EU can withdraw each equivalence decision unilaterally. In such an event (which has not yet occurred), counterparties could no longer use CCPs based in the country concerned to fulfil their obligations under EMIR. It typically takes several years for the Commission to reach a decision on a request for equivalence from a non-EU country.
20.39The Commission says that the current equivalence regime for oversight of third-country CCPs falls short. It has concerns that ESMA cannot effectively conduct on-going supervision of the CCP’s internal practices, and there is no mechanism for the EU to be informed of wider regulatory changes in the country where the clearinghouse is established. It argues that this problem will become more acute with Brexit, because as much as 75 per cent of euro-denominated interest rate derivatives are cleared in the UK. As a result, the Commission says, “a substantial volume of transactions denominated in euro would cease to be cleared in the EU and would no longer be subject to EMIR and the EU supervisory architecture”.
20.40As a result of both the increased cross-border trade in OTC derivatives, and the implications of Brexit, the Commission argues it is necessary for the EU to legislate now to ensure that non-EU CCPs which “play a key systemic role for EU financial markets” are subject to “safeguards provided by the EU legal framework”. The EMIR II proposal would therefore expand the powers of ESMA and the CBIs to recognise and supervise third-country CCPs.
20.41Under the Commission proposal, when considering recognition of a non-EU CCP, ESMA would have to distinguish between clearing houses which “are, or are likely to become, systemically important” (tier II) and those that are not (tier I). This determination would be made based on indicators such as the CCP’s size, the value of transactions it clears in EU currencies, and its links to the wider financial system.
20.42For tier II CCPs, a number of additional supervisory requirements would apply before they can be recognised for the purposes of the clearing obligation:
20.43The most far-reaching element of the Commission proposal is found in the new article 25(2c) of the Regulation. This would allow ESMA and the relevant CBIs to conclude that a third-country CCP is “of such substantial systemic importance” that, even if it demonstrated full compliance with the additional supervisory requirements for tier II clearing houses, it would be insufficient to “ensure the financial stability of the Union or one or more of its Member States”. If such a determination is made, ESMA has to ask the European Commission to confirm its assessment that recognition should be refused. If the Commission concurs, the CCP would need to relocate to an EU Member State to be able to provide clearing services under EMIR.
20.44The Economic Secretary submitted an Explanatory Memorandum on the second proposal to amend EMIR in July 2017. He was critical of the Commission’s intentions with respect to the location policy for third country CCPs, writing:
“The Government does not support the inclusion of location requirements for substantially significant third country CCPs in the proposal (“location policy”). […] A location policy is inconsistent with [a global approach to CCP regulation] and would risk fragmenting global derivatives markets. Market fragmentation in turn would increase the cost of trading and clearing, acting as a drag on growth and could discourage firms from hedging their risks using derivatives markets.”
20.45Placing the proposal in the context of Brexit, the Minister added that the UK “stands ready to discuss any legitimate concerns about the future relationship between EU authorities and UK CCPs and vice versa after the UK’s exit from the EU”. In a letter dated 24 August on the state of play on the EMIR REFIT proposal, he also clarified that the Government, in addition to wanting to negotiate a “comprehensive and mutually beneficial trade agreement with the EU that incorporates arrangements for cross border provision of financial services” post-Brexit, is also seeking a “transitional mechanism to minimise disruption and avoid cliff edges”.
20.46EMIR does not impose any requirements on the location of CCPs established lawfully within the EU. Under article 14, authorisation of a CCP granted by the national competent authority of any Member State is “effective for the entire territory of the Union”.
20.47However, in 2011, the European Central Bank (ECB) attempted to implement a new location policy for CCPs considered to be systemically important to liquidity in the Eurozone. It would have required clearing houses with a large exposure to euro-denominated derivatives to relocate to the Eurozone, and thus come under the direct supervision of the ECB. This would have effectively required the relocation of some UK-based CCPs to the Eurozone.
20.48The UK Government, supported by Sweden, launched a legal challenge to the ECB’s policy before the EU’s General Court in September 2011. The UK put forward five “pleas in law” in support of its request for annulment. The first of these contended that the ECB lacked the necessary competence to impose the location requirement. The other four pleas related to the substance of the policy, alleging notably that the location requirement infringed both the freedom to provide services and the free flow of capital within the internal market, as guaranteed by the Treaty on the Functioning of the EU.
20.49The General Court invalidated the ECB’s location policy for CCPs in March 2015. The judges agreed with the UK’s first plea, that the Bank did not “have the competence necessary to regulate the activity of securities clearing systems”. Having found that the ECB lacked competence, the Court did not assess the UK’s challenges to the substance of the location policy.
20.50In July 2017, the European Central Bank renewed its efforts to obtain regulatory oversight over clearing houses with systemic importance for the Eurozone. A proposal to the European Parliament and the Council for an amendment to its Statute would authorise the Bank to “make regulations, to ensure efficient and sound clearing and payment systems, and clearing systems for financial instruments, within the Union and with other countries.” This would, in effect, grant the competence the General Court said the Bank lacked previously to establish a location policy for clearinghouses. On 3 October 2017, the European Commission issued a favourable opinion on the ECB’s proposal.
20.51The ECB has not indicated how it intends to use its new regulatory powers, if the Parliament and Council agree to amend the Bank’s Statute. It is unclear whether it would seek to re-establish the location policy for CCPs, in light of the Commission’s proposal to introduce new supervisory arrangements – including a potential location requirement—for “tier II” non-EU CCPs. However, in its proposal, the ECB notes that it should have the power to “monitor and assess the risks posed by EU and third-country CCPs that clear significant amounts of euro-denominated transactions”, including “regulatory powers to adopt binding assessments and require remedial actions, as well as powers outside of the EMIR framework to impose additional requirements for CCPs clearing significant amounts of euro-denominated transactions”.
20.52The Minister submitted an Explanatory Memorandum on the ECB proposal on 20 July. With respect to its implications for the UK, he notes only that “the Government will carefully consider (…) any proposals that extend the powers of the ECB beyond the EMIR framework and provide the ECB with specific, stand-alone powers in relation to EU and third-country CCPs”, including “any interactions between the ECB’s recommendation and the recent Commission proposal to enhance the supervision of EU and third country CCPs”.
20.53Separately, in its response to the House of Lords Report on “Brexit: Financial services”, the Government argued that “it is not clear that the rules of the single market even after Britain has left would permit the ECB to require euro denominated instruments to be cleared inside the Eurozone”. However, in view of the parallel proposal from the Commission to amend EMIR, it is irrelevant whether a CCP clearing euro-denominated derivatives must be based in the 19-country Eurozone or the 30-country Single Market, as under the Government’s plans the UK will be a member of neither.
20.54All three legislative proposals to amend or supplement EMIR are now under consideration by the European Parliament and the Council. Their formal adoption is not expected until 2018 at the earliest, although it seems likely the Commission will push for an expedited entry into force of the amendments so that they can take effect before the UK’’s formal withdrawal from the EU.
20.55Finally, in light of the importance of the financial services industry to the UK, we wish to consider the implications of Brexit for the clearing industry in more detail in light of EMIR’s existing legal requirements with respect to non-EU CCPS.
20.56The Minister has confirmed the need for a transitional arrangement between Brexit and the entry into force of any new joint UK-EU supervisory system for the clearing industry. This is in effect an acknowledgement that, when the UK ceases to be an EU Member State, its CCPs will become “third country” operators vis-à-vis the Single Market. This is, logically, the status the Chancellor envisages for these firms by saying the UK will be a third country come March 2019.
20.57However, we are concerned that the Government has not been fully open about the consequences of becoming a third country for this sector. Our CCPs will automatically lose their ability to perform a clearing role under EMIR. Instead, they will have to seek individual recognition from the European Securities & Markets Authority (ESMA), provided the EU agrees that the UK’s post-Brexit regulatory regime for OTC derivatives is equivalent to EMIR. This process normally takes years, as it involves a detailed legal assessment by the Commission of the UK’s future domestic version of EMIR as amended under the provisions of the Repeal Bill, and it is not clear this regime could be put in place by “Brexit day”.
20.58As a result, in absence of an interim arrangement, the trade in derivatives both between the UK and the EU, and within the EU itself, would likely be severely disrupted. It is unclear what the status of uncleared contracts would be where the CCP is based in the UK. It is unlikely there can be a smooth transition from one regime to the other without a transitional period during which UK-based CCPs would still be treated as if they were based in the EU. It is in both sides’ economic interest to avoid such a cliff edge, as it is unlikely that all EU-based counterparties would be able to switch to using clearinghouses based in the EU-27 given their more limited capacity and product offering compared to London.
20.59Unfortunately, the Minister has not provided any detail on how the Government’s transitional mechanism would work in practice. As such, we are unable to assess how it would obviate the “cliff edge” in March 2019. The European Council has only identified one option for a transitional arrangement, under which the UK would in effect have all the obligations of EU membership—including continued application of EU law—without representation within the EU’s institutions. It remains unclear whether this is also the status envisaged by the Prime Minister in September when she called for a two-year interim arrangement after Brexit during which UK-EU “access to one another’s markets should continue on current terms” under “existing structure of EU rules and regulations”.
20.60For the clearing sector, an equivalence regime is available which would allow UK-based CCPs to continue performing their clearing function under EMIR. However, it is unclear if that regime can be in place by March 2019. We have therefore urged the Minister to provide clarity as soon as possible about the interim arrangement the Government is seeking, and whether it would be acceptable to the EU.
20.61It is clear, in any event, that the use of a transitional mechanism alone does not solve the issues created by the UK leaving the Single Market. As we have described above, once the UK becomes a third country (whether in March 2019 or at the end of a subsequent transitional period), EMIR’s provisions on restricting British CCPs from performing a clearing function in the EU will automatically apply. We have therefore welcomed the Minister’s ambition for “heightened supervision, deep cooperation and clear coordination” as a way for the EU and the UK to jointly address the risks of clearing post-Brexit, rather than potential forced relocation of services currently provided by UK firms to the EU. However, again, we must express our disappointment that the Minister has not provided any description of the means of delivery for such an ambition.
213 See paragraphs 0.37 to 0.45 below for more information on EMIR’s equivalence regime.
214 EMIR does not formally prohibit counterparties from clearing their derivatives contracts through CCPs not authorised in or recognised by the EU, but doing so imposes significantly higher capital charges on banks and investment firms.
215 In November 2016, the Commission also for the recovery and resolution of CCPs at risk of collapse, which our predecessors considered in their Reports of and . Negotiations on this proposal are on-going in the Council and the European Parliament, separately from the EMIR package.
216 submitted by HM Treasury (3 July 2017).
217 from Stephen Barclay to Lord Boswell (24 August 2017).
218 The Bank of England’s Financial Policy Committee has that failure to reach an agreement with the EU on derivatives clearing would mean that “after Brexit, firms may lose the permissions required to perform regular ‘life cycle’ events in these contracts, such as trade compression or exercising options. Tens of thousands of counterparties could be affected, representing around a quarter of both UK and EU client uncleared derivative contracts”.
219 See .
220 The Commission proposal also introduces a system according to which a third-country CCP may continue to rely on the rules and requirements in its own country, called “comparable compliance”, as long as its national system of regulation meets EMIR’s requirements and EU supervisory standards for CCPs. A finding of “comparable compliance” would allow ESMA to waive the imposition of the corresponding requirements of EMIR.
221 See .
222 submitted by HM Treasury (11 July 2017).
223 The Sunday Telegraph, ““ (13 August 2017).
224 For example, Article 25 EMIR prevents CCPs established in a third country from providing clearing services to EU-based clearing members or trading venues except if it has been recognised by ESMA, which in turn requires a decision by the European Commission that the OTC regime of the third country in question is “equivalent” to EMIR.
225 The UK of EMIR, including its provisions on third country CCPs, in July 2012.
226 The only current mechanism for a non-EU country to avoid being classified as a “third country” for the purposes of Single Market legislation is the EEA Agreement for EFTA members. to the EEA Agreement provides that “Rights conferred and obligations imposed upon the EC Member States or their public entities, undertakings or individuals in relation to each other, shall be understood to be conferred or imposed upon Contracting Parties, the latter also being understood, as the case may be, as their competent authorities, public entities, undertakings or individuals”.
227 Although EMIR has an “equivalence” regime which allows non-EU CCPs to perform a clearing function under the Regulation, it is unlikely this could take effect on “Brexit day”. See paragraphs 0.55 to 0.61 below.
228 It appears unlikely the other Member States would allow the UK to remain in the Single Market for financial services only, even if the UK agreed to apply the relevant legislation. The Guidelines on Brexit adopted by the European Council in April 2017 state: “Preserving the integrity of the Single Market excludes participation based on a sector-by-sector approach. A non-member of the Union, that does not live up to the same obligations as a member, cannot have the same rights and enjoy the same benefits as a member.”
229 A derivative is a financial contract that derives its value from the performance of an underlying asset or entity, such as a currency, interest rate or commodity. They can be used as a hedge, for example against exchange rate fluctuations, or speculatively, for example to bet that a company will default on its debt obligations.
231 AIG was the subject of a US Government bail-out totalling $180 billion. It had sold a large amount of OTC derivatives called credit default swaps (CDS), which insure the buyer against some other loan (for example a mortgage) defaulting. AIG had not set aside sufficient capital to cover claims against it under the CDS when the other loans started to fail.
232 See: .
233 Central clearing counterparties (CCPs) act as a safety mechanism in the OTC market, placing themselves in the middle of every sale (they effectively become the buyer to every seller and the seller to every buyer), reducing risks of chain reactions or financial instability if either the buyer or the seller of the derivatives contract cannot fulfil their obligations. As a result, the risks of the derivatives market are concentrated in the CCPs.
236 CME Clearing Europe, ICE Clear Europe Limited, LCH.Clearnet Limited and LME Clear Limited. There are 17 CCPs as a whole.
237 See COM(2016) 857: under Article 85(1) of Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories.
238 See . Our predecessors considered the Recovery and Resolution Regulation in their Reports of and . Negotiations on this proposal are on-going in the Council and the European Parliament, conducted separately from the EMIR package as it is not concerned with authorisation and supervision of CCPs per se. The proposal remains under scrutiny in anticipation of further information from the Government.
239 Our predecessors considered the report in January 2017. See: (38314) 14828/16: Twenty-fifth Report HC 71–xxiii (2016–17), (11 January 2017). It remains under scrutiny.
240 See .
241 See .
242 Pension funds are exempted from the clearing obligation because they do not typically hold the necessary cash or liquid assets to fulfil the margin requirements imposed by EMIR. To impose the clearing obligation would necessitate the diversion of their invested funds, ultimately reducing the income they can provide for their customers in retirement.
243 The Commission argues that suspension of the clearing obligation may be necessary, for example if the CCP clearing the biggest portion of a certain OTC derivatives class has exited that market.
244 submitted by HM Treasury (3 July 2017).
245 See paragraph 0.23.
246 See .
247 Separately, the Commission has also proposed a new recovery and resolution framework for CCPs at risk of collapse. The previous Committee considered that proposal on and .
249 More information on individual equivalence decisions is available .
250 Recognition refers to a decision by ESMA to allow a specific non-EU CCP or trade repository to be used to fulfil the clearing or reporting obligation under EMIR. Recognition can only be granted where the country where the CCP or repository is based has already been granted an equivalence decision by the European Commission (see paragraph 0.x).
251 The Commission proposes to give itself the authority to adopt a delegated act to lay down the detailed criteria for the determination of a third country CCP’s tier.
252 from Stephen Barclay to Lord Boswell (24 August 2017).
254 Action brought on 15 September 2011—United Kingdom v ECB ().
255 (4 March 2015).
256 See .
257 Com opinion on ECB.
258 submitted by HM Treasury (20 July 2017).
259 See: ““. We note in this respect that this is irrelevant for UK CCPs, as the Government has repeatedly stated its intention to leave the Single Market in March 2019.
260 The only current mechanism for a non-EU country to avoid being classified as a “third country” for the purposes of Single Market legislation is the EEA Agreement for EFTA members. to the EEA Agreement provides that “Rights conferred and obligations imposed upon the EC Member States or their public entities, undertakings or individuals in relation to each other, shall be understood to be conferred or imposed upon Contracting Parties, the latter also being understood, as the case may be, as their competent authorities, public entities, undertakings or individuals”.
261 The Bank of England’s Financial Policy Committee has that failure to reach an agreement with the EU on derivatives clearing would mean that “after Brexit, firms may lose the permissions required to perform regular ‘life cycle’ events in these contracts, such as trade compression or exercising options. Tens of thousands of counterparties could be affected, representing around a quarter of both UK and EU client uncleared derivative contracts”.
262 The European Council state: “Any (…) transitional arrangements must be clearly defined, limited in time, and subject to effective enforcement mechanisms. Should a time-limited prolongation of Union acquis be considered, this would require existing Union regulatory, budgetary, supervisory, judiciary and enforcement instruments and structures to apply.” (April 2017)
263 Prime Minister, ““ (22 September 2017).
28 November 2017