On 28 November 2016, we managers at Thomas Murray were concerned to see the publication of:
COM(2016) 856 final 2016/0365 (COD)
Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on a framework for the recovery and resolution of central counterparties and amending Regulations (EU) No 1095/2010, (EU) No 648/2012, and (EU) 2015/2365
We understand that this is a first legislative draft, and write in the hope that it will be very significantly amended.
Thomas Murray is an independent analytical and advisory firm, which for 24 years has assessed the post-trade space. Its coverage is global. One area of focus has been infrastructures, and notably central clearing houses (CCPs), particularly since the transformation in their role as set out in the G20 Communique issued in Pittsburgh in 2009.
We express our concerns via a posting, because the European Parliament is not calling for public comment on this draft. It judges, wrongly in our view, that the prior consultation on central clearing in 2012 suffices - yet like much of the financial system, the segment has been significantly modified since, most especially by the introduction, at the behest of the authorities, of over-the-counter derivatives into the risk books.
To begin, we find the premise of this draft EU legislation wrong – if the Parliament is attempting to build walls around the European Union in case of a fundamental problem with these systemically-important infrastructures, the goal may be understandable but remains unworkable all the same. From that, it follows that the risks faced by a CCP are not reflected in their complexity, and most certainly not with the urgency for action that would have to be taken in the event of a problem. From a cursory read, its procedural recommendations would take days to sort out, by which time “the game” would be over.
- Article 42 describes a “bridge CCP,” controlled by the resolution authority to receive and hold the instruments of ownership and some or all assets. Today, do staffers at a resolution authority actually know how to clear trades of assets and contracts? If the legislation passes as drafted, will the authorities communicate that there will be such a thing as a bridge CCP on standby, and how it will work? How and by whom will it be funded?
In the minutes and days after resolution of a CCP is underway, where will new contracts go for clearing? Presumably, third-country assets will be invited and expected to accept a transfer to the bridge CCP? Whilst we find that it is not per se a bad idea to have an off-the-shelf CCP ready at the flick-of-a-switch to fill the very big gap in the capital market that would open up, it must be properly prepared, its workings detailed and published beforehand. The text describes the conditions to be met when deciding that a clearing house can no longer be recovered and must be liquidated, but there is little description of the collaboration to be expected between the failing CCP and the resolution authority that would take over at that point. This gives the impression that the authorities are setting the stage to grab a very thorny problem. They may end up with bleeding hands.
What does the mere mention of a bridge CCP do for moral hazard, or is the expectation of the marketplace already well beyond that point?
- Article 45 speaks to government stabilisation tools, including potential public funding. Point 1.c states that financial support must comply with the Union State aid framework, but that usually precludes specific hand-outs. If the CCP is floundering, what kind of timeframe is entailed? Would there really be time to get through the EU state aid review?
- Article 46 allows for public equity support, if the modified structure is managed on a commercial and professional basis. Can a resolution authority run a market infrastructure on a commercial and professional basis? That is not generally one of its areas of expertise. Would it do so with staff from the floundering CCP? Would key managers co-operate and stay on, or would they walk to more attractive professional positions?
- Article 47 cites the possibility of a temporary public ownership tool. We have seen in the past that in this context, temporary can often stretch for years. Several firms saved with public funds in 2008 remain partly government owned, more than eight years later. Does the tax-paying public have appetite for more of this?
- Article 48 empowers the resolution authority, covering such matters as converting debt to equity or wiping out any liabilities of a CCP being liquidated. We find it worrisome that the resolution authority conducts the liquidation, rather than a court of law, at least as now drafted. Also, it was unclear to us whether clearing continuity would be provided by the bridge CCP or a potential acquirer. The public interest continues to be at stake: what should the “fair” allocation of losses be between the old and new structures?
- Article 50 provides for the appointment of a “special manager” who may replace the board of a CCP being liquidated. This person would be endowed with “all the powers of the shareholders and the board of the CCP.” This concentration of authority would violate the most basic governance principles elaborated over the past two decades, not least the bedrock OECD / G20 Principles. Common sense would call for various sources of information to be brought to bear at such a difficult time, in other words group decision-making.
- Article 53 states that in “respect of assets, contracts, rights, liabilities, obligations and instruments of ownership of persons in or governed by law of third countries,” the resolution authority may require that the CCP take all necessary steps to make the action effective. As seen later on in this Open Letter, Title VI of the proposed legislation is highly problematic, even verging on the inflammatory, when it comes to inter-governmental collaboration outside the European Union. Elements of Article 53 should be drafted more carefully to assure effective co-operation across borders.
- Article 55 gives power to suspend any payment or delivery obligations of both counterparties to a contract from the publication of the notice of suspension until midnight the next working day. In the same vein, Article 56 states that the “resolution authority may prevent secured creditors of a CCP under resolution from enforcing security interests in relation to any assets of the CCP …” as from the publication of this notice until midnight next working day. While such practices may have been used during the liquidation of a specific clearing member, there are few if any recent precedents for the resolution of the CCP itself. It is not clear to us how participants would respond to such short-term freezes.
- Article 59 defines the actions of resolution authorities’ as executive orders, in accordance with national administrative competences and procedures. We find it troublesome that a court of law would not be in charge of the proceedings.
Title VI on the international implications of this legislation poses grave concerns. From the perspective of a third-country CCP that has gone to very considerable lengths to seek recognition from ESMA as to its regulatory equivalence:
- Article 74 does not make mention of a qualifying CCP or a recognised CCP. This distinction was critical in past regulatory work, so are we now to understand it has no weight on plans?
- Article 75 (1) refers to international agreements. It is not clear to the reader which agreements figure in this text.
- Article 75 (3)(d) grants all-encompassing powers to the resolution authority. The problem is that with equivalence, powers and authorisations work bilaterally. In the case of margin collateral posted for central clearing, it is often held in multiple jurisdictions, which must co-operate to evaluate and share remaining assets, in order to assure orderly liquidations. Here the EU appears to want to act alone. Past successes in orderly, multi-lateral liquidations show that collaboration actually does work to balance CCPs’ books without impacting non-defaulting members, or nearly so.
- Article 76 would confer the “…Right to refuse recognition or enforcement of third-country resolution proceedings.” If a problem occurs elsewhere, can and would the EU authority ignore proceedings outside the Union, “…if there would be adverse effects on the financial stability in a Member State, or if there were to be a different treatment for the EU participants in that liquidation, or if there would be a material fiscal implication for the EU member state, or it were to be contrary to national law.”
- Article 76 appears to attempt to build “walls” around the EU. If this reading is correct, this would be an extreme version of extra-territorial effect of legislation, one that would not go down well in other capitals. It would appear to attempt to allow EU authorities to get out of current agreed commitments. For example, if the national resolution authority in an EU country were to judge that the recovery and resolution actions being taken in the United States were to be detrimental, and presumably justify that decision, that authority could simply refuse to recognise what the US authorities want to do. Today, the US and EU authorities have determined that there is equivalence in regulatory outcome, so by extension of that principle the US authorities would be right to determine that they may not recognise what the European Union authority is doing. This firm is quite certain that the authorities ought not to be proceeding down this road. We have no trouble imagining that if the authorities in Washington were writing in such terms, Brussels would be up in arms.
Simply put, those Europe-based CCPs that would be of the gravest concern to European authorities have very significant international participants with business and assets in multiple clearing houses around the world. Any resolution work that does not take this point into account at the outset will run off course. If the EU authorities cannot face the complications of derivatives markets working across borders, then they should order those positions wound down now – though this would not be Thomas Murray’s preferred course of action, either. This firm encourages law and regulation that fits and frames business.
- Article 77 does establish the basis for national authorities to enter into prior standing agreements with official counterparties elsewhere on the matter of resolution, in order to set up processes and arrangements for handling these matters. It is not clear to readers, who are not briefed in the details, how these agreements would be written. Given the stakes and the complexities, considerable compromise would be a necessity – and the spirit of Title VI is not encouraging in this regard.
And doubtless our least favourite provision falls under Title VII, which would call for amendments to existing EU Regulations. Under Article 80, the clearing obligation during resolution may be suspended for specific classes of OTC derivatives for which the suspension is requested. The entire G20 effort since 2009 was precisely to get OTC contracts into central clearing, and yet the only provision for suspension of the clearing obligation is for this one class of contracts. So more than six years on, what was this global policy about?
In August 2016, the Financial Stability Board issued a call for comment on CCP resolution, to which this firm responded. In common with that draft, the EU legislative proposal weaves back and forth between instances of recovery and of failure / liquidation of the infrastructure. If the clearing book cannot be brought back into balance, then an orderly wind-down is called for. The authorities must write clearly as to which side of that dividing line they are on at every point in their documents.
If Thomas Murray’s reading of this draft is incorrect, that would only underscore the importance of public consultations to straighten out potential misunderstandings between the authorities and the marketplace.
The author, Thomas Krantz, is Senior Advisor, Capital markets, in the firm of Thomas Murray; and served as Secretary General of the World Federation of Exchanges (2000-2012). The views expressed are his own, and not necessarily those of the firm.