The BIG Interview: FIA

The TRADE speaks to the Futures Industry Association (FIA) head of Europe Simon Puleston Jones on the current state of the clearing industry, MiFID II, and the impact of Brexit.

Joe Parsons: What is the current environment for clearing banks?

Simon Puleston Jones: Clearing was always a low margin business, but that is more true now than ever for many firms. Of all the constraints, the leverage ratio under Basel III has received the most attention, as it limits the ability of clearing firms to take on new clients and to accept a porting-in of additional business upon the default of another clearing firm

In recent weeks, the European Commission has acknowledged that the leverage ratio as originally proposed by the Basel Committee works against the G-20 mandate to promote central clearing. It has therefore proposed that the leverage ratio be amended to recognise the exposure reducing effect of client margin. If these changes to the capital rules are completed, then the capacity of the industry to facilitate access to clearing should increase.

JP: Will then European clearing banks have an advantage over US banks?

SPJ: The current US administration has not proposed to adopt those changes. We continue to believe in the importance of global coordination in standards that promote financial stability and therefore hope that the new US administration will give this critical issue some further consideration, to avoid US banks being put at a disadvantage to their European peers.

The leverage ratio is part of the package of measures that determines a bank’s balance sheet capacity to clear clients’ business. So what we may see is a potential increase in the bandwidth among European banks to clear for clients and a continued restriction on the capacity of its US counterparts.

JP: How has the industry adopted to the next wave of mandatory clearing?

SPJ: The go-live of category two counterparties clearing for G-4 denominated IRS has marked another milestone in the progress to mandatory clearing. We have focused our efforts on the clearing obligation for swaps and the indirect clearing of ETD (exchange traded derivatives), as we look to the next milestone for category three clearing. There is a proposal to delay the go-live for category three counterparties clearing for swaps, largely because of the lack of indirect clearing arrangements for cleared OTC, but not for ETD indirect clearing, which currently remains set for 3 January 2018, and which was designed in the first place only to make the arrangements consistent with cleared OTC. It would be inconsistent if the issues identified by ESMA in their consultation result in a postponement (or even possible exemption) for category three clearing for swaps, yet those very same counterparties that face the same challenges to ETDs have to comply with explicit indirect clearing requirements.

That is an acute problem for two reasons. One is timing – we still await the final RTS relating to indirect clearing under MiFIR. It will take time for the industry to implement MiFIR-compliant indirect clearing in a scaleable way. We have significant concerns about whether firms will be compliant by 3 January 2018 in the absence of those final rules being published in the very near future. Second, unlike swaps clearing, where you are creating a new regulatory obligation for firms to clear, in the ETD space those same counterparties may have been clearing for decades, but risk losing that access to clearing if MiFIR-compliant indirect clearing arrangements are not put in place in time.

JP: What effects will this have down the clearing chain?

SPJ: In its draft RTS, ESMA stated that the clearing chain can only be so long. Several of our members have clearing chains that are longer than the length permitted by ESMA. Impacted clients would lose access to clearing ETDs come 3 January 2018 unless clearing firms and their clients can find a way to shorten that chain. Part of the complexity is that ETD markets are global – firms that provide clearing services are not clearing members of every clearing house for which they provide clearing services. They may themselves use intermediate brokers to access certain CCPs. Accordingly, even the largest investment banks in the world will sometimes act as a direct client under MiFIR, rather than as clearing member under MiFIR clearing arrangements – and when acting as a direct client, that effectively lengthens the clearing chain.

JP: What cross-border complications will this create?

SPJ: The jurisdictional scope of MiFIR’s indirect clearing rules remains to be clarified. We have had many conversations with the European Commission, ESMA and NCAs on this and we continue to work with them to identify where the various parties in the clearing chain need to be located in order for MiFIR to apply. It is a level one issue in the regulation and so there has been some reluctance to clarify the scope by way of Q&A.  The lack of clarity on this critical points leaves some real implementation challenges for both buy-and sell-side alike.

FIA members are keen to agree and promote common standards regarding account structures for indirect clearing, so as to reduce the cost and complexity of implementation. 

JP: How is the clearing industry prepared for the implications of Brexit?

SPJ: We need to ensure there is no disruption to the ability of end-users to manage their risk by trading, clearing and reporting derivatives via the market infrastructure of their choosing.

To do that, one needs to consider all aspects of the clearing chain. The need for transitional arrangements that grandfather the existing regulatory approvals of UK market infrastructure for a period of time following the completion of the Article 50 period is clear. Certainty is also needed as soon as possible as regards whether firms located in the UK will be able to continue to service EU clients from the UK post-Brexit, or whether they will have to move some of their business to continental Europe. If it is the latter, that takes time. The two years that comprise the Article 50 process is insufficient.

JP: Is there a high probability euro-denominated clearing will stay in London?

SPJ: FIA’s position is that the market should determine where derivatives, of any sort and of any currency, are cleared. At the moment, the market has chosen London as its clearing destination of choice for OTC swaps, but that could of course change over time. Clearing is a mechanism that operates most efficiently the more you put in one place, so as to derive maximum benefits from increased netting, margin offsets, compression, product margining etc. 

One of the risks of forcing the clearing of a given product into a smaller geography is that the liquidity the markets have found today by choosing where to clear becomes fragmented across multiple venues, with the result that you lose those operational efficiencies, increase operational risk and increase costs for end users. 

To address the apparent concerns of the ECB and others regarding oversight, what we have observed in recent weeks is a focus on joint oversight of UK market infrastructure by UK and European regulators. This is the model adopted by the CFTC in the US under its DCO registration process for offshore clearing houses. CFTC chairman Massad recently explained that the CFTC is able to manage its way through Brexit relatively easily, because it already has the access to all the information that it needs with respect to UK clearing houses.