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Central Counterparties & Brexit

Central Counterparties & Brexit

Central Counterparties & Brexit


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Brexit is creating uncertainty over the future supervision of the UK's central counterparties (CCPs), which represent major concentrations of derivative trading risk. An unexpected change in the status of UK CCPs could be highly disruptive for European capital markets. Banks must be alert to the potential risks, and should prepare for closer scrutiny into their planned responses.

Central counterparties and clearing venues (CCPs) have played an essential role in post-crisis efforts to reduce systemic risks in the global financial system. Central banks and securities commissions see the use of CCPs to clear over-the-counter trades as an important component of financial market stability.

However, the resulting concentration of risk could have its own systemic consequences, in the event of a CCP being disrupted. ECB Executive Board member Benoît Cœuré highlighted the potentially destabilising effects of CCP failure, and the importance of careful supervision, in a recent speech European CCPs after Brexit, speech by BC at the Global Financial Markets Association, Frankfurt am Main, 20 June 2017.

The prospect of Brexit is throwing this issue into sharp focus. London is a major centre for Euro-denominated derivatives clearing. According to ECB estimates, it accounts for around 90% of Euro-interest rate swaps and 40% of Euro-credit default swaps. Confusion over the terms of the UK's withdrawal from the EU is creating uncertainty over future supervisory collaboration between the UK and EU-27, both during a transition period - if there is one - and thereafter. The European Commission's recent proposals to amend EMIR raise additional questions about the future shape of European financial market oversight.

In short, it is possible that Brexit could cause LCH and other UK-based CCPs to lose their EU status as `zero risk counterparties' for new transactions, or even for all outstanding trades. Such an event would have major consequences for European capital markets. Some immediate impacts could include:

  • A jump in regulatory capital risk-weightings for banks' positions at UK-based CCPs; and
  • Large, volatile movements in the comparative cost of using UK CCPs compared with venues within the EU-27. When this difference, sometimes called `CCP basis spread', moves unpredictably it can have serious financial consequences for market participants. 

An increase in capital costs or CCP basis spreads would prompt many banks and brokers to transfer clearing activity away from London to CCPs in other Member States, or perhaps to new EU-27 subsidiaries of the UK CCPs. That could involve the transfer of hundreds of thousands of trades, with a notional value in the trillions of Euros.

This would be an unprecedented event, with further unpredictable consequences. For example, because clearing is at its cheapest when positions can be netted, such a large directional shift could push up the cost of clearing at all European CCPs. Transferring risk to new CCPs would also pose huge operational challenges for market participants in terms of technology, staffing and risk management. And initial margin requirements could be a significant drain on liquidity.

Overall, the likely impact of this kind of market disruption would be:

  • To erode profitability for banks and brokers;
  • To increase the costs to issuers, such as governments and companies, and investors such as insurers and pension funds; and
  • Potentially, to exclude some institutions from certain markets. 

These are outcomes that supervisors will be keen to avoid. Indeed, in June 2017 the ECB formally asked to amend its own Statute in order to bring CCPs within its supervisory remit European commission press release database

KPMG member firms have extensive experience in helping financial institutions to mitigate the consequences of market disruption. Some useful areas of expertise include helping organisations to evaluate and plan for the risks of market disruption; modelling and managing market risks and their impact on regulatory capital, accounting and balance sheet; and working with financial institutions and software vendors to make CCP interfaces more flexible.

Brexit could have a profound impact on European CCPs. At a minimum, banks should be aware of the potential for market disruption, and prepared for supervisory questions about their planning and responses. They also need to be alert to the possibility that pre-emptive action by market participants could increase, not decrease, the risks of disruption.

KPMG member firms have dedicated teams to support clients' business transformation that go hand-in-hand with Brexit on a broad scale.

For further information please contact Joe Cassidy, Partner and Brexit Banking & Capital Markets Lead.

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