European Regulators’ Recommendations Affirm EuroCCP Proposal
In a report aimed at increasing the safety and soundness of central counterparties (CCPs) in the European Union, the region’s central banks and securities regulators recommend that interoperating CCPs in Europe prudently manage the risks arising from their linkages. These recommendations affirm the concerns raised by EuroCCP in recent months. The report from the European System of Central Banks (ESCB) and Committee of European Securities Regulators (CESR) could bolster support for an Interoperability Convention to be signed by all CCPs that interoperate, a proposal EuroCCP made public in mid-June.
Interoperability risks
Interoperability – the arrangement among CCPs that enables market participants to choose which CCP they use – is the next stage in Europe’s market evolution. The arrival of new pan-European trading platforms and the expansion of stock exchanges beyond their national markets have given trading firms more choice of trading venues and reduced their trading costs. Interoperability among CCPs, when fully implemented across Europe, introduces competition in clearing by enabling market participants to use the CCP of their choice regardless of where they trade.
But interoperability involves certain risks, as the ESCB and CESR recognize. In their report issued June 23 (Ref. CESR/09-446), the two authorities recommend that clearing houses conduct risk assessments before establishing links with each other, and that such links be built and operated in a way that effectively reduces the risks associated with the link. In particular, the report advises, “regulation and contractual rules should be designed such that no CCP is exposed to unexpected obligations or distortions of rights/obligations vis-à-vis the other one.”
As the ESCB/CESR report implies, much of the risk of interoperability stems from the fact that CCPs differ, sometimes significantly, across key parameters like membership standards, collateral requirements and risk management procedures. With interoperability, weaknesses in one CCP are no longer isolated to that entity. Furthermore, while CCPs’ raison d’être is to protect their participants from the failure of a counterparty, CCPs themselves can go bankrupt. The default of a CCP that interoperates with others could have wider and more complex market impacts than the failure of a large trading participant, notes the report.
EuroCCP proposal
To date, four CCPs – EuroCCP, Fortis EMCF, LCH.Clearnet Ltd. and SIX x-clear – have announced plans to interoperate, and more may join this roster in the coming months. Although multiple bilateral agreements might seem the quickest path to activating interoperability, bilateral contracts cannot capture the multilateral nature of interlinked CCPs.
While bilateral agreements are a step in the right direction, establishment of a single, standard Interoperability Convention, signed by all CCPs, publicly disclosed and accessible to market participants, trading venues and regulators, would mitigate interoperability risk. By making clearing houses’ interoperability arrangements transparent, such a convention also would accelerate the connectivity process across Europe and enhance the region’s ability to attract investment capital as the global recession abates.
EuroCCP has been promoting an Interoperability Convention this year in discussions with fellow CCPs and with regulators, and in a June 17 press release the company went public with its proposal. While the ESCB and CESR recommendations calling for contractual terms that reduce the risks arising from interlinking CCPs add weight to the rationale for an Interoperability Convention, they are purely advisory.
Interoperability negotiations are now underway between EuroCCP, Fortis EMCF and SIX x-clear on the principles and procedures for serving clients in the Nasdaq OMX Nordic markets of Denmark, Finland and Sweden. The agreement crafted here could become the foundation of an Interoperability Convention to be used by all interoperating CCPs throughout Europe. @