EMIR 3 – EU gloves coming off (soon)

What is EMIR 3?

At the end of last year the European Commission released its proposal for EMIR 3, the latest in a series of reforms of European trading. This latest proposal includes a crucial intention to move a significant proportion of euro derivatives trading to EU CCPs, which will have significant implications for both the EU and the UK.

This would involve allowing third-country Tier 2 CCP equivalency to lapse for certain derivatives products. Practically, this means that three major euro-denominated products and one zloty product cannot be cleared through London Clearing House (LCH), but must instead be cleared with an EU CCP.

The European Commission has clearly decided that now is the time to pull the trigger on moving euro trading onto the continent, with the expectation that the talent, infrastructure etc. will be in place by June 2025. The move will affect cleared trades conducted in euro with Tier 2 CCPs outside of EU member states. In reality, barring the odd trade here or there, this refers to LCH.

Affected products are:

• Interest rate swaps in euro.
• Interest rate swaps in zloty.
• Short-term interest rate derivatives in euro.
• Credit default swaps in euro.

Why has the EU decided to do this?

The incentive for the EU is obvious – why should trading in their flagship currency be cleared overseas under the purview of a foreign regulator? Moving clearing onto EU soil will allow the EU’s regulator, ESMA to intervene as necessary, and give the EC control in the event of a crisis – avoiding the risk of products identified as having ‘substantial systemic importance’ being based overseas. The proposal mentions that ‘concerns have been expressed…about the ongoing risks to Union financial stability arising from the excessive concentration of clearing in some third-country CCPs, in particular due to the potential risks that can arise in a stress scenario’. The current Brexit exemption (Reg No 648/2012) was always temporary, and is considered ‘insufficient to manage the risks to Union financial stability’.

A nice additional bonus is that this move will transfer a huge chunk of trading (and all the talent, liquidity, and business that goes with it) from LCH to the two CCPs based in Frankfurt (Deutsche Borse and Eurex).

What is ISDA unhappy about?

Having to accept worse prices at EU CCPs may lead to less business for EU banks who are stuck with the systemic risk calculation limit at LCH, whereas UK banks have no such limit, and therefore might be more attractive as counterparties. However, forcing a huge chunk of business into EU CCPs should result in markedly higher liquidity in the EU, compared to LCH.

ISDA’s press release included these descriptions of potential consequences…

• …‘less commercially viable for EU market participants to clear through CCPs based outside the EU’;
• …‘harmful to EU capital markets’;
• …‘make EU firms less competitive’;
• …‘negative impact on the derivatives market, EU clearing members/clients (EU investors and savers), and Capital Markets Union’;
• …‘costly to implement’.

ISDA have flagged in their EMIR 3 commentary that requiring all EU firms to open new accounts at EU CCPs takes time, especially when all firms try to do so simultaneously. The EMIR proposal does mention that a significant proportion – 60% – of EU clearing members already have an active IRS account at an EU CCP, and 85% have an active CDS account.

It is no surprise that ISDA has objected – as a large part of its remit is to flag up potential flaws in pending legislation, especially when many of its City-based members will see a loss of business through this move.

Elsewhere, the Futures Industry Association (FIA) generally welcomes EMIR 3’s measures, but has raised a red flag over the active account requirement (that EU-domiciled firms must have active accounts at EU CCPs) considering it ‘detrimental to risk management, operational efficiency and broader EU competitiveness’. They further disagree with the specificity of ‘quantitative thresholds’.

What is the current situation?

The mechanism by which this transfer will take effect is through the lapse of the current exemption, put in place as a Brexit transitional arrangement. Under this policy, UK Tier 2 CCPs (i.e. only LCH) can be used for unrestricted euro trading as a form of equivalence with EU CCPs. This exemption is due to lapse in June 2025, after which a certain amount of euro trading must occur in-EU.

It is currently difficult to estimate the number of trades that will need to be transferred (by whatever means is eventually chosen) to EU CCPs, but it is safe to say that the number will be in the tens of thousands. This will presumably entail a large-scale legal and accounting operation in order to smoothly shift a significant proportion of the global euro derivatives market from one CCP to another.

What is the likely impact?

Despite ISDA’s fears, it is entirely possible that euro liquidity in the EU CCPs quickly grows to enable a healthy trading environment and competitive prices, rather than remaining at a level that disadvantages the CCPs’ trading partners, compared to the situation at LCH. Correspondingly, LCH’s euro liquidity pool will be significantly impacted, as parties shift the bulk of their euro trades to Frankfurt (and put up the required capital sums at its CCPs). In this scenario, even UK-based banks that have little oversight from ESMA are almost certain to follow their European colleagues to Eurex and Deutsche Borse, to access the healthier euro liquidity pool created by the shift. It is currently possible to ‘net’ across currencies (e.g., dollars and euros) at LCH. This will not be possible after these reforms because the dollar liquidity will remain at LCH but the euro liquidity will move to Europe, fragmenting the existing pool. While LCH’s liquidity drying up could be somewhat dangerous, it is likely that the situation will stabilise, with lower liquidity being complemented by lower exposure.

As detailed below, there are a number of important questions that need to be answered, but is certain that a significant amount of legal work will be needed to ensure that replacement contracts are in place across the transition, and it is unrealistic to expect all arrangements to be in place overnight.

The three big questions:

1. Are legacy contracts included?
   1. If so, will they be included from day one, or at a later date?
2. What proportion is enough to satisfy the systemic risk calculation?
   1. 50%+1? 66%? 70%? The number has not yet been indicated.
3. Does this affect indirect client contracts?
   1. Downstream contracts between clearing members and their counterparties, those parties and further counterparties, etc.

Are legacy contracts included or not?

Not including legacy contracts would not fulfil the systemic risk purpose of the move – only requiring new contracts to be conducted in-EU, and allowing all legacy contracts to remain based at LCH, will only gradually result in a market shift to ESMA-regulated territory. If a (highly unlikely) meltdown occurred at LCH in the next few years from June 2025, the EU would still be exposed to the kind of systemic risk it currently considers LCH posing to the stability of the EU economy.

Taking their statement at face value, it is highly likely that legacy contracts will be included. Changing their location from LCH to one of the two primary EU CCPs can occur through 3 methods, all of which requires time and effort:

1. Court-ordered novation:
   1. Complicated: involves time, effort, and expense.
2. Termination of LCH trades and replacement with new EU CCP trades:
   1. The market will have changed since the trades were first placed. In order to reflect new market prices, it is likely that some adjustment to the trade will have to be made to reflect this, whether to price or coupon.
   1. There could be questions about the accounting and tax treatment of hedging trades, which will be involved in some cases.
   1. The CDEA does not typically envisage transferring trades from one CCP to another.
3. Novation:
   1. A party can replace the counterparty exchange (LCH) with a new one (EU-based). This would be the practical route if we presume two things:
      1. LCH agrees – we can assume this.
      1. It is possible to replace LCH with an EU-based CCP on all trades with a low number of new contracts (ideally, one). If every single trade has to be manually novated, there will be tens, or hundreds, of thousands of amendments required. It might be possible for one master contract to be amended, with a long annex containing every single trade affected by the move.
   1. It is possible that there will be a two-stage process, with new trades expected to be majority-cleared in-EU from date 1, and any remaining legacy trades to be novated in-EU by date 2. If the rough duration of a swap is ~3 years, then date 2 could be 2-3 years after date 1. This would allow a gradual process as new trades are cleared in-EU without disrupting the hundreds of thousands of legacy contracts in place, with only a smaller number of long-term trades requiring novation at date 2.

The simple fact is that we do not know yet whether legacy contracts will be included. The answer from the EC or ESMA will allow more complex timetabling and calculations to be carried out.

How much is enough to satisfy ESMA’s systemic risk calculation?

The threshold will be decided by ESMA, the European Systemic Risk Board (ESRB), and the European Central Bank (ECB), with ESMA as lead regulator. As yet there is no indication of a set percentage of trades that have to be conducted through EU CCPs to satisfy their requirement of avoiding systemic risk.

However, it is reasonable to assume that, at the very least, a bare majority of euro trades by EU-based parties must be conducted with EU CCPs, if not significantly more. Tinkering around the edges won’t reduce systemic risk. This will introduce another threshold calculation for EU banks trading euros at LCH. For example, if the threshold were 70%, firms would have to ensure that a 28% trading portfolio at LCH doesn’t accidentally turn into 31% of a firm’s trading.

Does this affect indirect client contracts?

This change will also affect downstream parties. While it is obvious that a big clearing bank changing CCPs will require novation, their documentation with their own clients must also be changed to mirror the CCP-clearing member contract. Each of these trades are governed by a CDEA and the LCH rulebook, even if LCH isn’t a party. As identical legal documentation is required, and if a new rulebook is substituted, then these contracts will be affected.

Clearing members will have a large number of clients. Each of those clients will then have to novate their contracts further downstream with their own client list to ensure that the cleared trade is mirrored down the whole train and to eliminate legal basis risk.

Other aspects of EMIR:

While the euro clearing requirement is the standout move from EMIR 3, the European Commission has also outlined a number of other proposals affecting derivatives trading:

Intragroup exemptions:

EMIR contains an additional proposal to replace the current equivalence framework that exempts intragroup transactions from clearing obligations/margin requirements with a list of jurisdictions for which exemptions that cannot be granted (i.e., all other jurisdictions automatically allow for the exemption). This category of jurisdictions will be based partially on already-existing EU risk lists (based on tax, money laundering, and terrorism financing), and partially ad-hoc based upon the Commission’s identification of third-countries that are not relevant to the exemption, or present additional counterparty risk or legal risk. Rather than the assumption being that a jurisdiction will only have an intragroup exemption if equivalence is granted, under the new regime a jurisdiction is assumed to have the exemption, unless it is named on a blacklist.

ISDA ‘strongly supports’ removing equivalence as a pre-condition for intragroup exemptions from clearing and margining requirements. However, ISDA disagrees that ESMA should have discretion in granting intragroup exemptions, saying that the move ‘creates uncertainty and should be removed’.

Clearing thresholds:

Post-implementation, third-country CCP trading, in the absence of any equivalence decision, will contribute to clearing thresholds. The natural implication is that the clearing thresholds for those EU entities with existing positions at LCH will effectively be lowered. In contrast, trades cleared through EU CCPs or recognised third-country CCPs would be carved out from the clearing threshold positions.

Non-financial counterparties

NFCs can no longer take part in client clearing, and can only maintain accounts at CCPs for trading on their own basis. This stems from liquidity problems arising for energy and commodities traders in the aftermath of the Russian invasion of Ukraine.

The EC also proposes to reintroduce reporting requirements for intragroup transactions where one member is a NFC. The Commission’s proposal notes the importance of some NFCs (particularly energy companies and commodities firms) to the overall market, and argues that a lack of reporting on these trades, even though they are primarily used for internal hedging, could contribute to systemic risk.

There will also be changes to reporting formats, from .CSV to .ISO, in line with the SFTR. The requirement to be up to date with reporting methods comes into place from 2024.

Conclusions

The post-Brexit gloves are off, with the long-threatened move to transfer clearing services to EU domiciled entities. While the European Commission’s argument in respect of systemic risk is valid, given that EMIR and UK EMIR are currently identical, it does rest on a high degree of perceived future regulatory divergence. Commercially, the proposal is the first big post-Brexit broadside from the continent and will likely result in a significant diminution in the UK’s primacy in derivatives clearing. If the move survives the trilogue process – and it will– there is very little that the City’s institutions, the FCA, or the UK Government can do in response. A move to restrict sterling swaps clearing to UK borders would be akin to a pea shooter to the EU’s cannon, as sterling swaps are traded in significantly lower volume.

After all, who can begrudge the EU wishing to keep an eye on euro trading in-house? Likewise, there is little that the UK can do in retaliation, as there is negligible sterling clearing in Europe. This is likely to be something of a fait accompli.

As explained above, it is not possible to draw detailed conclusions from the data until technical standards are released. There is a great difference between, say, a 50%+1 requirement, and a 90% one. Likewise, the timeline and scope of the move needs clarification. Let’s wait and see what the EC and ESMA release on this topic, especially in relation to the concerns raised by ISDA. This proposal contains significant reforms, and it is going to be impossible to pass this proposal through the trilogue process without details being released in advance for discussion (and certainly well in advance of the Regulatory Technical Standards in June 2025). Even in the absence of these numbers, dates, and mechanisms, it is clear to see that this will have a significant impact on both sides of the channel.

Update – 9th March

On the 9^th March, Risk.net published an interview (paywall) with two senior members of ESMA’s CCP supervisory committee, Klaus Löber and Nicoletta Giusto. They emphasised the need to wait for further information to come out during the European Parliament and Council’s amendment process, and no further numbers were put to thresholds.

However, it is interesting to note the direction of ESMA’s interest in CCP regulation. They indicate a desire to take a more active role in regulation of third-country CCPs (i.e., ICE Clear Europe for CDS and LCH for the other products). Löber noted that the weaker ESMA’s regulatory powers over third-country CCPs, the higher the in-EU clearing threshold would need to be.

Löber and Giusto also had concerns about the preponderance of regulators, each with conflicting and overlapping aims and powers. As well as ESMA and NCAs (National Competent Authorities), central banks and other regulatory bodies (e.g., the European Systemic Risk Board) also have powers over CCPs. Under the current rules, CCPs do not need to report to ESMA, only to their NCAs, potentially resulting in an incomplete picture of systemic health. EMIR 3 will introduce a requirement for firms to report average activity at each CCP for various parameters to their NCA, who must submit it to ESMA.

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