US Commodity Futures Trading Commission Chairman Timothy Massad and European Commissioner Jonathan Hill have agreed on a common approach to harmonizing transatlantic regulations regarding the central clearing of derivatives by clearing houses, or central clearing counterparties (CCPs). This historic agreement allows market participants to utilize clearing infrastructures in both the US and Europe and assures a level playing field for US and EU CCPs.
Prior to this agreement, US and EU regulators had been unable to unite their efforts to regulate CCPs under a unified regulatory regime. CCPs interpose themselves between counterparties in derivatives transactions to ensure future performance of open contracts and mitigate the transaction risk posed by potential defaults. Given the extent to which the derivatives market is driven by cross-border transactions between the US and Europe, the lack of unity in their approaches to derivatives clearing created a costly and complex regulatory framework.
Under the agreement, concluded in February, the US and the EU will harmonize their clearing requirements and work together to oversee CCP compliance with a more uniform set of rules.
For its part, the EU will require customers of clearing houses to post more margin, allowing it to align with US standards. To implement the agreement, the European Commission intends to adopt an “equivalence decision” regarding CFTC requirements. Once recognized by the European Securities and Markets Authority (EMSA), the “equivalence decision” will permit US CCPs to continue providing services in the EU by complying with CFTC requirements. They will also be considered a “qualifying CCP” under the European Capital Requirements Regulation, thereby lowering costs for European banks.
The EU’s equivalence decision is conditioned on a determination that CFTC-registered US CCPs have internal policies and procedures to ensure that: (1) sufficient initial margin is collected to satisfy a two-day liquidation period for clearing members’ proprietary positions in exchange traded derivatives; (2) initial margin models incorporate measures to mitigate the risk of procyclicality; and (3) default resources are maintained to withstand default by two members with the largest credit exposure.
The aforementioned conditions will not apply to US agricultural commodity derivatives traded and cleared domestically, since such markets are relatively isolated from the larger financial system.
Correspondingly, the US will require more margin to be posted by members of clearing houses – such as banks – to align requirements with EU standards. In discussing the agreement, Chairman Massad suggested that “CCPs on both sides of the Atlantic will be held to high standards and that the CFTC and European authorities will work together on oversight of these CCPs.”
The CFTC plans to adopt a substituted compliance determination allowing EU CCPs to adhere to CFTC’s rules by complying with corresponding European requirements. This determination will apply to EU CCPs already registered as derivatives clearing organizations (DCOs) with the CFTC, as well as those planning to register with the CFTC under the substituted compliance regime.
The agreement comes in advance of the July 21, 2016 deadline for phasing in mandatory derivatives clearing in the EU. Without the accord between the US and EU, European banks using US clearing houses would have faced a significant increase in capital requirements for transactions occurring from July 21 forward.
While ESMA has up to 180 working days to consider a recognition of equivalence, the European regulator has indicated that it plans to recognize the decision as soon as practicable once US CCPs meet their conditions under the decision. The CFTC has also indicated that it plans to streamline the registration process for EU CCPs seeking to register with it through the substituted compliance program.