Banks and regulators alike are breathing sighs of relief after the recent announcement that the US and European Union have reached an agreement on critical issues around derivatives regulation.
The deal ends a long standoff between the Commodity Futures Trading Commission in the US and the European Commission, the executive arm of the EU. For the past three years, these two entities have been at bitter odds over the implementation of common standards for the derivatives market. The impasse has threatened to fracture the derivatives market and cause massive disruption to banks and institutional investors throughout Europe and the United States. Read on for a breakdown of the issues at the heart of the new agreement, and what is expected to happen now that a deal has been struck.
What caused the long impasse between the EU and the US?
The sticking point in talks was a concept known as equivalence, or mutual recognition; specifically, the mutual recognition by the EU and the US of each other’s rules regarding clearinghouses. Also known as central counterparties (CCPs), clearinghouses act as intermediaries in derivatives trades, providing transparency and accountability and mitigating counterparty risk, thus helping to prevent a marketwide collapse. Their use has been greatly expanded since a G20-level agreement made after the 2008 financial crisis attempted to reduce systemic risk by mandating that all standardized derivatives be centrally cleared.
Difficulties between the US and the EU arose when European policy makers were unable to agree that US clearing regulations were equivalent to their own. The European Commission grants equivalence to a non-EU regime based on three conditions: first, that the non-EU country has in place an effective equivalence system to establish how its domestic firms are permitted to use EU clearinghouses; second, that clearinghouses based in non-EU countries are subject to ongoing, effective supervision and enforcement; third, that non-EU clearinghouses are in compliance with rules that are considered by the EU to be at least as strong as the European Market Infrastructure Regulation (EMIR). While the European Commission believed that US rules fulfilled the first two conditions, the third condition became a point of contention: the EU did not believe that US rules were equivalent to EMIR.
What is the difference between US and European regulations?
The key difference between the two countries’ regulations concerns the initial margin, or the amount that must be put up against each trade in order to cover the potential costs of a default and protect other members from defaulting. Under EMIR regulations, clearinghouses must calculate margins based on the assumption that it will take a period of two days to clear the position of a defaulting member; under US rules, the applicable time period is only one day. These different timeframes influence the amount of margin that must be posted by a counterparty. Of the two approaches, the EU’s is more stringent.
In addition, the US does not require the application of an “anti-procyclicality” measure, which helps ensure that margin rates do not either fall too low in healthy economic conditions or, conversely, rise too quickly in times of economic stress. Under EMIR, the anti-procyclicality measure is a requirement.
What would a non-equivalence situation mean?
When a country is deemed equivalent, banks are permitted to hold less collateral against whatever trades are passed through EMIR-equivalent clearinghouses. If the clearinghouse is not EU-approved, however, the charge jumps much higher, meaning that European banks choosing to clear trades in non-equivalent countries like the US would face steep capital charges, making business unduly costly and potentially sparking a market fracture.
What happens now that an agreement has been reached?
Under the new deal, both the EU and the US agree to adjust their respective rules related to the margin. In general terms, the EU will move closer to the US position regarding how much margin must be posted to clearinghouses by clients of banks; in exchange, the US will move closer to EU standards on the margin that banks themselves must post at clearinghouses. These adjustments will be achieved through discussions among European regulators and changes to the rule books of US clearinghouses, respectively. The result will be that European clearinghouses can do business in the US more easily, and US clearinghouses can continue to offer services to EU companies.
A particular achievement of the new agreement is that it manages to address rule adjustments without forcing the reopening, by either party, of underlying legislation. Furthermore, regulators hope that the deal will pave the way for making other equivalence decisions, such as those regarding trading platforms and margin rules, within a quicker timeframe.