Lower clearing charges have begun to help European equity market participants to reduce their overall transaction costs, but true choice of central counterparties (CCPs) remains elusive. There are also fears that choice will come at the price of increased counterparty risk if a robust clearing and settlement directive for Europe does not set the rules for competition.
While MiFID focused predominantly on the trading of financial instruments, it touched the post-trade world in two key areas. Firstly, it aimed to facilitate cross-border trading in Europe. Secondly, its best execution requirement urged a focus on achieving the optimum result for a client beyond best price, which included cost and likelihood of clearing and settlement.
However, the directive provided neither the pan-European post-trade framework required for efficient cross-border transactions, nor the choice of central counterparty (CCP) implied by its best execution principle. Trading firms were effectively stuck with the incumbent clearing houses of the trading platforms they used and could not, for example, choose a single clearer and use it across all venues.
To fill the gaps, the European Commission introduced the Code of Conduct for Clearing and Settlement in November 2006, which aimed to, among other things, establish links between clearing houses that would cut costs and provide choice.
Three years on, the code can be considered a partial success at best in the three areas it was designed to tackle – price transparency, access and interoperability and unbundling of services and accounting.
The access and interoperability segment has had a particularly poor success rate – only one link is currently live. And although a flurry of new agreements were forged in Q2 this year, they have hit a regulatory wall. UK, Dutch and Swiss watchdogs are now scrutinising the links because of fears about inter-CCP margin requirements.
Relying on a voluntary code to encourage rivals to share business was arguably expecting too much. However, regulators’ concerns about interoperability agreements underscore a deeper flaw in the code – it seeks to establish links between clearers that do not have common risk management and operational requirements.
This could create a situation where interoperating CCPs try to encourage their national regulators to match the lowest common denominator in the name of competition. Put another way, CCP members may pay for more choice with less protection against counterparty risk.
A further problem is that the agreements that have been signed so far are bilateral, and so the risk management arrangements contained therein are invisible to all but the two interoperating CCPs and their respective regulators.
The lack of visibility presents difficulties for clearers because if they choose to link with a rival that has other connections, they are exposing themselves to risk they are incapable of measuring or managing. It is also a headache for CCP members, who would be equally incapable of assessing the true risk of using a particular clearer.
In a bid to solve this problem at the CCP level at least, pan-European clearing house EuroCCP has proposed a standard interoperability convention to give linking clearers the comfort that they were all managing risks according to the same set of guidelines. However, the proposal has so far failed to gain the support of EuroCCP’s peers.
The industry, therefore, has high hopes for the European Commission’s proposed legislation to strengthen Europe’s clearing houses in preparation for tackling a greater flow of over-the-counter derivatives. The proposals would introduce common safety, regulatory and operational standards for CCPs, as well as recognition of third-country clearers. The European Council gave its seal of approval to the proposals last week, saying it ‘broadly welcomed’ the EC’s initiative.
Some feel common standards will remove barriers to interoperability. Others are not so sure – reservations about opening up to rivals are likely to prevail. Nevertheless, many agree that the EC’s proposals will make CCP use safer for all.
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