The Wrong War

The first shots were fired back in July 2011. The European Central Bank issued a ‘policy framework’ in which the idea was expressed that infrastructures clearing euro-denominated transactions should be based within the euro area, on vaguely-delineated stability grounds. The fuss was about clearing of euro-denominated interest rate swaps at LCH’s SwapClear facility, and the objective was to repatriate euro-related activity to a eurozone state. Why that was necessary was never really made clear.

Much has happened in the intervening years. The complete list of battles in the war for clearing of euro-denominated swaps is long. There are, however, some notable events in this long-running saga:

• EMIR, the EU Regulation which imposed regulatory standards on EU-based CCPs, was passed into law on 4 July 2012. Slipped into the regulation, as a reaction to the 2008 financial crisis, was the world’s first legally binding rule obliging dealers and end-users to clear interest rate swaps at CCPs. The case for centralising clearing of high-risk products was never made, at least not in a dispassionately researched and validated way: it was just said that clearing ‘worked well’ during the crisis, so it followed that clearing was required for better systemic stability. Even if you don’t agree that this was dogma rather than science, it is undeniable that more interest rate products have been pushed into clearing, concentrating the counterparty risk into the handful of CCPs who do this business, and making them into systemically important bodies. If the case for worrying about stability of CCPs was weak before 2011, it is now very strong.
• The United Kingdom’s voters chose on 23 June 2016 to leave the European Union. If clearing of euro-denominated instruments in a non-euro EU Member State was already a cause of concern in Frankfurt, clearing in a non-EU country must surely heighten the concern. Brexit has raised the stakes.
• Since Brexit, the EU’s legislative bodies have repeatedly modified EMIR to make it difficult for EU persons to clear significant volumes of higher-risk products outside the EU. EMIR 2.2 (which came into force on 1 January 2020) put CCPs into risk tiers, with LCH Ltd being in the high-risk ‘Tier 2’ category. But although a ‘you must relocate’ option was written into EMIR 2.2, that hasn’t been used. In a further attempt to legislate for repatriation of clearing, EMIR 3.0 (agreed on 7 February 2024, but not yet in force) imposes a requirement on EU firms to carry out some of their clearing in EU CCPs.

It may be foolish to make predictions about how this may play out. But some things are clear enough. First, it has proved very difficult to shift clearing out of LCH. Clearing members will tell you how hard it is to transfer a portfolio of business, much of which belongs to clients. Economists will tell you about network effects and tipping points. Whether the new ‘active account’ requirements will provide the conditions for a geographical shift remains to be seen.

Second, though, the rationale for trying to move clearing out of LCH Ltd and into the euro area is still very vague. It is said that excessive exposure is bad for EU financial stability in a crisis. Many official policy statements about the subject are confined to general remarks about stability and systemic risk (clearing is essential, CCPs are systemically important) which are difficult to parse. But ESMA has articulated the case more precisely. In its view, the dangers come to the surface when there is a crisis which threatens the viability of LCH Ltd. That could cause EU firms to lose access to clearing, and EU clearing members would have to shoulder the end-of-waterfall costs. Those concerns are worth examining.

Loss of access to clearing can’t be a real reason, if other CCPs exist which are willing to take on the trades; and in any case, clearing is only important because EMIR made it mandatory. If one of the EMIR powers to disapply the clearing mandate were used, the absence of a key CCP would not matter. And it’s far from obvious why the risk is worse because the at-risk CCP is located outside the EU: even within the EU, there is no central resolution authority for CCPs. Neither the ECB nor ESMA would be in the driving seat in the event of a CCP crisis, anywhere.

Sure, clearing member firms would be stuck with default-related costs if there is default which blows through the defaulter’s margin and junior lines of a CCP’s post-default defences. That, however, is a universal truth, and again has nothing to do with geography. What does have to do with geography is the quality of supervision of the non-EU CCP and the robustness of its risk models. Which are things that ESMA can look into, given than it has categorised LCH Ltd as a ‘Tier 2 CCP’, but over which ESMA would be powerless if the CCP were based in the EU.

So, the real arguments for repatriation of clearing are either unspoken or poorly explained. There is an array of possibilities, such as de-concentrating, reduction of size and risk, bringing liquidity to EU markets, or taking regulatory control. Not many of them bear close scrutiny. Sometimes it has been said that having a CCP is a symbol of national prestige, so it is an embarrassment that London does the EU’s clearing. Less emotively, prestige is shorthand for the fact that CCPs make good returns for their owners: the primary business risk is borne by customers, not shareholders, in an inversion of normal investor economics. But, if we were to complete the risk equation, it would be necessary to solve the end-of-waterfall conundrum: nobody knows who picks up the final, final tab if a CCP is in very great difficulty. Or rather, nobody wants to say that the only person left standing would likely be the central bank, which may have to intervene if there is a genuine threat to financial stability because a CCP has failed. So maybe repatriation is a good plan, because it would put the ECB in the driving seat after all, whereas a foreign central bank could have different priorities.

This gloomy scenario might seem a bit far-fetched. It is certainly the case that a twenty-first century CCP failure would be a catastrophe of unprecedented proportions. But a CCP’s failure would be consequential on another failure of unprecedented proportions: the CCP’s risk management would have broken down, and that will only have happened because of a monstrously large default or a non-default risk event such as has never been experienced before. Either of those things is not going to be an event confined within the walls of a CCP. The entire financial system would be affected, the crisis would be far worse than that of 2008, and the inability to clear interest rate swaps is going to be the last thing on anyone’s mind, even the central bank’s.

Perhaps, then, we need to look a bit closer to the everyday to find out why there is still a policy drive to get euro products cleared in the eurozone. There are two main areas in which central banks are legitimately concerned with the behaviour of CCPs clearing instruments denominated in the currency for which they are responsible.

• Monetary policy. The central bank’s job is to maintain price stability. If the activities of a CCP could interfere with money or credit supply that could be a source of conflict with the central bank. As the ECB itself has put it, ‘The large payment flows between CCPs and their participants mean that inadequate financial risk management of CCPs could transmit serious financial strains to institutions that are Eurosystem monetary policy counterparties. Interconnected payment systems and repo markets, which are essential for monetary policy transmission, could be equally affected.’[1] This is a good argument for giving the ECB an oversight role and early warning of any disruption. But what would happen differently because the problem is unfolding in Frankfurt rather than London is not specified. Even this rationale seems a bit too vague to explain why firms should clear euro-denominated products in the EU.
• Collateral policy. Much has changed since the 2008 crisis in this area, with QE taking centre stage and vast demands being placed on financial firms for high-quality collateral for liquidity coverage, central bank liquidity operations, and mandatory margining of derivatives trades. Collateral is as important as cash in monetary operations, but collateral markets are highly complex and rarely researched. Governments, not central banks, control the supply of the most highly-desired collateral instruments. But central banks intervene in collateral markets in various ways: in bulk buying and selling, in determining repo rates, in defining haircuts and eligibility and transaction types and so forth. These interventions are powerful. If we add clearing into the picture, evidently euro-denominated securities will be the collateral of choice for margining positions in euro-denominated instruments. So clearing which takes place overseas may give the ECB less visibility over collateral than it would wish. Further, some empirical data suggests that haircuts applied by CCPs for margining diverge from those applied by central banks for monetary operations, when a market event (short of default) arises. It would therefore not be a surprise if central banks wish to assert some degree of control over CCPs’ margining policies to avoid excessive distortion in the collateral market.

Perhaps, somewhere in this, lies a real explanation for the desire for control over clearing of euro products. But if it is to have any real meaning, the ECB should first obtain supervisory control over EU-based CCPs. The second shot in the war over clearing was the case brought by the United Kingdom against the ECB, which led to a European Court of Justice ruling that the ECB has no jurisdiction over CCPs. That state of affairs continues, and while it does, the legislative war against market participants who wish to clear outside the EU seems somewhat futile.

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