On 13 March 2019 the European Parliament and EU Member States reached agreement on legislation that appears so arcane that many wonder why a small but important group of global regulators and central bankers are so excited about it: regulating global – and European – derivatives markets. While this topic is immensely technical, it also matters deeply because derivatives have financial stability implications. Patrick Pearson, head of unit and policy expert at the European Commission, explains in more detail.

Central Counterparties

The issue at stake revolves around the clearing of derivatives trades in entities referred to as Central Counterparties or ‘CCPs’. As trading derivatives bilaterally between financial firms was one of the causes of the 2008 global financial crisis, the G20 leaders agreed in 2008 to regulate this market and require derivatives trades to be routed through and cleared by CCPs.

EU regulations that were adopted after the crisis – in particular the European Market Infrastructure Regulation (EMIR) – has now made the financial system safer and stronger. There is an additional €2 billion of collateral in the system and EU rules and supervision have closed gaps that were missed before the crisis. By design, clearing houses have now become the central risk hubs of the global derivatives markets. Over the past few years risk has accumulated and concentrated in these CCPs. The departure of the UK from the EU has also put the need to improve the EU’s oversight of this sector in sharp relief as the UK has dominated the global derivatives sector, clearing trillions of euro-denominated trades each day.

The recently agreed improvements to EMIR will give EU regulators, and the European Securities and Market Authority (ESMA) in particular, a much needed better view and understanding of any risks that CCPs from outside the EU could bring to the financial stability of the EU or one of its Member States.

As a first step, ESMA will need to identify those third-country CCPs that it believes could impact the stability of the Union’s financial system through the type and volume of transactions they clear and risks they import into the EU – the European Commission will clarify these criteria through further rules. At present, more than 30 CCPs from 16 countries outside the EU access and provide clearing services in the single market; this number will of course increase after the UK’s departure.

All of these CCPs will be ‘tiered’ by ESMA according to their systemic importance for the EU. Depending on how systemic a CCP is deemed to be the new rules allow ESMA to require those CCPs to take the necessary measures to address any concerns. The current degree of documentation, information and supervision over systemically important clearing houses will also be upgraded compared to what is required today. If necessary, and as a last resort, certain activities of non-EU CCPs could even be required by the European Commission to be undertaken from within the EU. The role of EU central banks in these matters has also been increased in view of their important responsibility for financial stability. A recommendation to revise the ECB Statute has also been considered, but was recently dropped by the ECB as it felt it was not necessary to achieve the objectives of the new EMIR rules.

Equivalence

The agreed improvements to the EMIR regulation also include enhancements of the European Commission’s current system of ‘equivalence’ which grants access to the Single Market. A new system of so-called ‘comparable compliance’ has been introduced so that third-country CCPs can themselves request to have some of their own rules applied instead of EU rules. In addition, ESMA will have a new role in monitoring regulatory and supervisory developments in third countries that have been declared ‘equivalent’ by the Commission.

ESMA will also have further responsibilities for CCPs within the European Union. It will play a new and important role in coordinating and converging supervisory decisions and practices in a range of areas.

A number of technical legal acts will need to be put in place by the Commission before the new rules will be able to be applied. As usual, these will follow the Commission’s ‘Better Regulation’ approach and public consultations of all stakeholders will be organised first. The European institutions have also recognised the need to reconcile the static nature of legislation with market dynamics: the European Commission has been tasked to monitor market and regulatory developments closely and to present any necessary review of the rules three years down the line.

Read more on EMIR and CCPs