LONDON, June 20 (IFR) - Europe's bond issuers face billions of euros in additional costs when hedging their debt issues if the EU pushes ahead with a location policy for euro swaps clearing.
Industry participants warn that the €85trn euro swap market could splinter into onshore and offshore pools as a result of forced EU relocation after the UK's departure from the bloc, similar to Japan where a pricing basis has emerged between domestic clearinghouse JSCC and London-based provider LCH in yen swaps.
Bank of England governor Mark Carney warned this morning that attempts to split clearinghouses could fragment the global market and reduce the liquidity and cost benefits of central clearing.
“Any development which prevented EU27 firms from continuing to clear trades in the UK would split liquidity between a less liquid onshore market for EU firms and a more liquid offshore market for everyone else,” he said in his Mansion House speech.
“Fragmentation is in no one’s economic interest. Nor is it necessary for financial stability. Indeed it can damage it. Fragmenting clearing would lead to smaller liquidity pools in CCPs, reducing the ability to diversify risks and diminishing resilience.”
Costly to issuers
Proposals published last week by the European Commission aim to enhance supervision of third-country clearinghouses and leave the door open for the EU to force the most systemically important euro swaps clearinghouses to be located within the bloc.
That could prove costly for end-users based on evidence from Japan. Without regulatory recognition of international yen swap clearinghouses, domestic firms must clear their contracts in the Japan Securities Clearing Corporation, part of the Japan Exchange Group. International entities, meanwhile, use LCH's SwapClear, which clears 18 currencies and handles over 90% of the global cleared interest rate swaps market.
The basis between the two providers is typically around 1bp–3bp but is extremely volatile but has been as high as 5bp. According to one clearing head at a European house, that means bond issuers could end up paying an additional €10m to hedge €1bn over a 20-year maturity.
“We would be concerned about a small European CCP being subject to similar pricing differentials we see in Japan as although an additional 0.05% cost might not seem like very much, it actually turns out to be quite substantial for issuers,” said a clearing head at a European bank.
“With a smaller local CCP in euros, you might also worry about the level of mutualisation and resources available.”
While clearing in yen swaps is relatively well balanced between Tokyo and London, euro swaps clearing is heavily skewed towards non-EU based counterparties.
Euro contacts constitute just under 30% of LCH's total cleared interest rate swaps, but only a quarter of that portion represents activity from EU-based firms.
In his Mansion House address, Carney also acknowledged wider concerns around the tens of trillions of euros of existing interest rate swaps traded by EU firms that could become trapped in a clearinghouse no longer recognised by the European Commission.
“Those EU firms would face capital charges as much as 10 times higher than today unless they could move them,” he warned.
Carney stressed the need for greater supervisory cooperation following Brexit. He said that similar concerns were raised during his time as governor of the Bank of Canada and ultimately addressed through common standards and cooperative oversight, enabling Canadian dollar clearing to move to a more efficient and resilient London hub.
“The Bank of England also must concern itself with the resilience of CCPs in other European and non-European jurisdictions that are used by firms that we supervise,” he said. “These CCPs must be subject to robust regulatory standards and deep reciprocal supervisory cooperation.”
While the Commission’s proposals keep the door ajar for the EU to grab clearing activity from London, such action would only be considered for clearinghouses deemed to be the most systemically important by the European Securities & Markets Authority and in conjunction with the European Central Bank.
The key focus of the proposed rules, however, is to set out a framework for enhanced supervisory oversight of third-country clearinghouses, with input from the ECB, which was largely omitted from the regime in original EMIR text.
“The Commission proposals acknowledge the fact that EMIR in its existing state didn’t provide the tools to challenge that risk. What the proposals do is increase the number and nuance of tools in the toolbox to look at this challenge," said the clearing head.
"The ultimate option is still there through non-recognition approach, but the real concern is that it would have much more impact on European members than anyone outside of Europe.” (Reporting by Helen Bartholomew)