New EU rate-swap rule will deal a big blow to US

A few clearinghouses in the United States and Europe now manage most of the risk of the $550 trillion global swaps market. However, European Union law is set to prohibit U.S. central counterparty clearinghouses (CCPs) from clearing interest rate swaps for the largest EU banks on Feb. 21, and then for their clients, like investment funds and insurance companies, three months later on May 21.

This prohibition would give London Clearinghouse's (LCH) SwapClear a big leg up over U.S. rivals like the CME Group. It would also deal a blow to the competitiveness of the United States as a global financial center, as more clearing would move to Europe.

European Union flags in front of the headquarters of the European Central Bank in Frankfurt am Main, Germany.
Daniel Roland | AFP | Getty Images
European Union flags in front of the headquarters of the European Central Bank in Frankfurt am Main, Germany.

CCPs stand at the center of our financial system, because after the 2008 crisis the G-20 countries agreed that most swaps should be cleared through them. This would, in theory, reduce systemic risk by collectivizing losses among the world's largest banks. Now, for example, about 70 percent or $230 trillion in interest rate swaps are centrally cleared, as compared to only 16 percent or $54 trillion at the end of 2007.

The world's largest banks act as dealers in this market by buying and selling interest rate swaps for their clients. Their clients include banks, investment funds, and insurance companies seeking to manage the risk that interest rate fluctuations pose to their large bond and loan portfolios. Non-financial companies also regularly use these swaps to reduce funding costs and plan for future payment obligations.

Reduced competition among CCPs would increase the cost of clearing and therefore the cost of using these swaps. It would also further concentrate their risk in Europe. The only way to avoid this outcome is for the European Commission to determine that U.S. CCPs are subject to equivalent regulation as EU CCPs before the deadlines pass. This is called recognition. Unfortunately, the European Commission has refused to do so for the past four years, even though it has done so for many other countries. Why?

At the outset, the commission has taken the position that it cannot deal with recognition of CCPs for swaps until it deals with recognition of CCPs for futures, like those for oil, Treasurys or contracts tracking the S&P 500. With respect to futures, the commission has argued that U.S. CCPs are not sufficiently safe. This is based on the fact that the EU rules require CCPs to collect sufficient collateral to cover potential losses over a two-day horizon while the U.S. only requires enough collateral to cover potential losses over one day.

However, the U.S. rules require CCPs to collect sufficient collateral to cover the gross exposure of all clients, whereas the EU rules allow for the netting of client collateral. Recently released analyses show that the differences between the U.S. and EU rules do not lead to a significant difference in the actual safety of the CCP. Indeed, EU regulators are now receptive to adopting the U.S. approach, but this is likely too far off to affect the deadlines.

One way out of the current stalemate would be for the CME to register in the EU just the way that LCH SwapClear has registered with the U.S. Commodity Futures Trading Commission. LCH SwapClear can clear for U.S. participants under U.S. rules and E.U. participants under EU rules. Unfortunately, EU law prohibits registration for U.S. CCPs.

What the European Commission would really like is for the CFTC to recognize EUCCPs. This would mean permitting LCH SwapClear to clear for both U.S. and EU participants under EU rules, while avoiding CFTC registration. The European Commission would then reciprocate by recognizing U.S. CCPs and ending the stalemate. This would be the best outcome, so why has the CFTC not done so?

First, it appears to be concerned that under this approach a U.S. investment fund or insurance company clearing a swap in Europe would not receive the bankruptcy protections of U.S. law. However, legal experts find that these U.S. clients could secure these protections without CFTC registration for the EU CCP.

Second, it may also be concerned that without registration it could not be sure that EU CCPs are safe. But CFTC registration is not necessary to ensure this result. The CFTC could remain fully informed about the practices of EU CCPs and if it found cause for concern about their risk management practices, then recognition could always be withdrawn.

It is possible that the European Commission simply does not want to resolve the situation, because failure to do so will give the EU a competitive advantage. However, intransigence by the CFTC will all but ensure that result. The best way out is reciprocal recognition—now.

Commentary by Hal S. Scott and John Gulliver. Scott is a professor at Harvard Law School and the director of the non-profit Committee on Capital-Markets Regulation. He is also the author of the law-school textbook "International Finance: Transactions, Policy and Regulation" and "The Global Financial Crisis." Follow him on Twitter @HalScott_HLS. Gulliver is the executive director of research at Committee on Capital-Markets Regulation. Follow him on Twitter @gulliver_john

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