The growth of central counterparties (CCPs) as a fundamental cog in the wheel of Europe’s financial markets has been driven by a regulatory regime that has consistently called for more on-venue transactions to be centrally cleared. As more and more instruments are added to the long list of those requiring central clearing, the number of CCPs has grown in tandem.
It is widely recognised that the regulatory changes have increased the overall costs of a transaction eroding the thin profit margins on trades. The post-trade costs are only adding to the costs of venues memberships and smart order routing required to achieve best execution. This could encourage market participants to do the exact thing that a regulatory shift sought to discourage. It leaves banks and tier one brokers searching for workarounds to central clearing.
Compounding this paradox and as the EU28 soon becomes EU27, this is not the only hurdle CCPs have to clear themselves.
The future role and location of UK CCPs in Europe, as we know them, remains a huge uncertainty. Whilst the risks of a ‘cliff edge’ for market infrastructure providers in the event of a hard Brexit – that is, negotiations that do not achieve a satisfactory level of legislative and regulatory equivalence—have been well-documented, the impact of this political scenario on the investor is less clear.
With UK CCPs managing over a quarter of global clearing activity, CCPs—and by default banks and brokers themselves—will soon find themselves non-compliant if transactions are not cleared and reported via an EU27 CCP.
If a hard Brexit comes to pass within the current regulatory framework, CCPs will be required to have a base in London as well as a base somewhere in the EU 27. This will require separate legal entities, which will need to be independently capitalised within each respective location.
Market participants would pay two bills if CCPs are both UK-domiciled and EU-domiciled, by virtue of having a second relationship with a CCP complaint with the European Markets Infrastructure Regulation and the Markets in Financial Instruments Directive. On top of basic operating costs, add in initial variation margins, insurance costs, split volumes, and costs per item, then the trading and settlement bill will all go up because the CCP will now rank lower in the volume-tiering system as the transactions cleared by each unit are halved.
In terms of the bottom line, CCPs may not have a choice of two worlds, but be forced to live with both. This will mean burgeoning layers of cost and, even under the simplest model, users would be faced with a two-fold increase.
As a result, the profile of CCPs could change dramatically. To satisfy regulatory demands, CCPs will either increase fees as it becomes more difficult for clearing houses to squeeze margins from each transaction, or absorb these costs themselves.
Banks and tier one brokers could opt to simply move clearing activity toward EU CCPs, targeting them with a higher volume of trades. But given 76 percent of companies that use a MiFID passport are based in the UK, this presents itself as a fundamental business challenge for banks, brokers and the market as a whole. It is not simply a workout for regulatory compliance teams, but a total shift in the wholesale market’s way of doing business.
In addition, if EU member states saw more reliance by clients on their services, their costs might increase significantly with the flow of demand, possibly creating a drag on liquidity. The volume of activity would have huge implications on the risk environment and could cause margin requirements to swell, causing technology and reporting costs to balloon.
If the trading infrastructure is ill-equipped to deal with the volume and market participants are forced to seek alternatives, there could be a period of over-the-counter (OTC) trading in which the market could carry more risk. In an environment like this, the part of the OTC transactions that previously cushioned a lot of the market disruption could instead force a financial impact on the market structure itself.
Faced with no other choice, as cost constraints are driven by the further transparency of MiFID II and without changes to the regulatory framework to accommodate CCPs, costs are likely to be passed on to the banks and brokers who rely on CCPs and, in turn, to investors.
Only a certain number can bear these costs, however. And these are most likely to be the larger CCPs who can navigate such a complex operating environment. In doing so, this risks reducing
the number of cogs that keep the wheels turning.
Too complex to fail?
As CCPs find themselves under pressure to reduce costs and become more affordable, some will be unable to do so profitably and might simply shutter their clearing businesses entirely. A central risk entity cannot run at a loss and such activity would have to be taken over by a competent legislative authority or a regulator.
To prevent this outcome, regulators would either need to revisit the existing framework or given that the systemic nature of CCPs is only set to increase, they would have to be bailed out by a lender as a last resort. A crude reality that ranks worst case scenario for all European supervisory institutions. The mantra of ‘too big to fail’ has become an established part of global financial acumen. A paradox of regulation and costs is driving CCPs to change and adapt, adding layers of operational, financial and geographical complexity to already complex business models. This fundamental shift may concentrate the market in the hands of the few as they overcome these hurdles, and these few may soon become just too complex to fail.
