The European Union and the United States agreed yesterday (10 February) to accept each other’s derivatives rules in a long-awaited step to avoid splitting the $550 trillion market.
Both sides of the Atlantic are introducing reforms after the 2007-09 financial crisis highlighted how the opaque sector for interest rate and credit default swaps accentuated uncertainty in rocky markets.
The bulk of derivatives are traded in New York and London but for the past three years the EU and United States had been unable to accept each other’s rules.
Without convergence, clearing houses and international banks, which handle most transactions, faced costly overlapping requirements.
“Finding common ground with our European partners to establish a level playing field internationally will help support cross-border activity with the appropriate regulation and supervision,” said Treasury Secretary Jack Lew in a statement.
The EU’s financial services chief, Jonathan Hill, and Timothy Massad, who heads the Commodity Futures Trading Commission (CFTC) in the United States, said they have agreed a common approach for clearing houses.
Clearing houses or central counterparties (CCPs) stand between two sides of a derivatives trade, ensuring its completion even if one side goes bust.
“It means that European CCPs will be able to do business in the United States more easily and that US CCPs can continue to provide services to EU companies,” Hill said in a statement.
Massad said that the agreement was critical to ensuring that global derivatives markets remain robust.
“It is a significant milestone in harmonising regulation of these markets,” he said.
Without the EU formally recognising US rules as being equally strict or equivalent to European rules, banks in Europe using an American clearing house would have to hold far more collateral, such as cash, to cover US trades from 21 June.
Massad told reporters he is confident that Wednesday’s agreement can be implemented before the 21 June deadline.
The International Swaps and Derivatives Association, a global industry body, said the deal means that banks in Europe can continue clearing with US clearing houses.
“There was a risk of real market disruption had this not been resolved,” said ISDA chief executive Scott O’Malia, a former CFTC commissioner.
“Hopefully, this paves the way for other equivalence decisions to be taken — for example, on trading platforms and margin rules — in a quicker time frame.”
Under the deal, Europe has agreed that customers of clearing houses must post more margin to move in line with tougher US standards. In return, the United States will align itself with tougher EU rules on margin posted by members of clearing houses, such as banks.
Massad said that the deal exempts US agricultural commodity derivatives trades because of their role in the US economy and importance for farmers and ranchers.
For the deal to be implemented CFTC commissioners need to grant the EU “substituted compliance,” meaning that European clearers can operate largely under EU rules when operating in the United States.
“They will vote on that soon,” Massad said.
The US watchdog will also streamline registration of European clearers that want to do business in the United States.
In return, the European Securities and Markets Authority said it will speed up its process for authorising US clearing houses.
Clearing houses or central counterparties (CCPs) are financial market infrastructures which enhance market and financial stability by guaranteeing the obligations of each counterparty to a transaction. Cleared transactions commonly include derivatives as well as other financial products such as bonds, equities and securities financing contracts. If a counterparty to a transaction goes into default before settling its obligations, its other counterparties are protected by the financial resources held by the CCP. These financial resources are largely made up of high quality collateral, which is calculated and collected from the counterparties on a daily basis. In this sense, the CCP acts as a circuit breaker, mitigating a domino effect of financial losses across the markets when one participant fails.
Recognising the importance of CCPs in mitigating risks in the financial system, G20 leaders committed in 2009 to make the use of CCPs mandatory for standardised derivatives contracts. Both the CFTC and the EU have now adopted rules to this effect, increasing the use of CCPs across EU and US markets.
As many derivatives are traded cross-border, EU and US market participants need access to CCPs that can serve both markets. This is why today's common approach is important: it enables EU CCPs to operate in US markets and US CCPs to operate in EU markets on a level playing field.