EU and Third Country Regulation: A World of Growing Divergence

The end of the Brexit transition period marks the start of a new regulatory era between the European Union and United Kingdom, with knock-on effects for other third countries. Headlines to date have centred on shifts in trading flows between London and Europe’s financial centres, and the prospects for asset management delegation arrangements. Post-trade issues have attracted less public and media attention. The impacts though will be no less momentous.

In the months and years to come, the relationships between the EU27 and third countries, and the degree of cooperation and divergence that emerge, will be at the centre of the regulatory agenda. This article explores the scenarios for the post-trade world.

Access to infrastructures

A key point will be access to Financial Market Infrastructures (FMIs), the institutions responsible for clearing, settlement and transaction recordkeeping that are critical to smooth functioning markets. Here the European Commission and UK authorities have already signalled their determination to keep transaction activity within their spheres.

Euroclear is an early example. London-based Euroclear UK & Ireland had long acted as the central securities depository (CSD) for Irish and UK securities. That ended with Brexit. Following the transition, Euroclear was granted a six-month equivalence relief period to migrate settlement of Irish securities to Euroclear Bank in Brussels, which took place in mid-March.

The situation for central counterparties (CCPs) is more complicated. The European Commission has granted the UK a temporary equivalence decision for CCP clearing services for financial stability reasons, with the grace period running until 30 June 2022. At this stage, it appears unlikely to be extended.

In the interim, the Commission is encouraging EU27 market participants to use the time to migrate their risk exposures from UK CCPs. Its Communication on the European economic and financial system, published on 19 January, sets out the Commission’s ambitions for strengthening EU FMIs and promoting the international role of the euro:

  • The Communication reiterated the expectation that EU clearing members and market participants reduce “excessive” exposures to systemically important UK CCPs, in particular their euro-denominated OTC derivatives exposures.
  • The Commission, together with the European Central Bank and other regulators, will collaborate with the industry via working groups to assess possible technical issues that could hinder the transfer of euro-denominated contracts to EU CCPs. The aim over time is to see a migration of the main native contracts and transactions to within the EU as well.

Recommendations on reducing EU market participants’ exposures to systemic CCPs will be issued by mid-2021.

Fragmentation risks

Maximising liquidity is key to CCP efficiency, providing clearing members with cross-margining benefits and clients with larger liquidity pools to limit their counterparty credit and settlement risks. Maintaining these benefits will depend on regulators encouraging other non-EU clearing members, especially UK members, to move their euro-denominated transactions to the European CCPs as well, to avoid fragmenting the liquidity.

Areas of UK divergence

The UK, as a leading architect of the EU’s regulatory framework, is unlikely to rip up its existing rulebook to become a low-regulation, high-risk financial centre. That said, areas of divergence are already emerging.

One is the Central Securities Depositories Regulation (CSDR). The UK Government has announced it will not adopt the regulation’s settlement discipline regime, with its measures for mandatory buy-ins, cash compensation for failed buy-ins and CSD penalty mechanisms. Market participants will rely instead on existing industry-led settlement discipline contractual frameworks.

Another is the share trading obligation under the Markets in Financial Instruments Regulation (MiFIR), which requires market participants to use trading venues when they exchange listed shares. The UK’s Financial Conduct Authority will employ its Temporary Transitional Power to allow UK firms to continue trading all shares on EU trading venues.

Reversing support for the MiFID II open access requirements – which stipulate trading venues and CCPs provide non-discriminatory access to one another – could be a third. Open access is a welcome development for market participants as it enhances transparency and competition, in turn promoting improved service and lower fees. Any UK backtracking would give succour to those EU member states that are also opposed to open access.

Maintaining alignment

With the expiry of the Brexit transition phase, communication and interaction between regulators on both sides will be key.

Divides with other third countries can be seen elsewhere. Since the European Market Infrastructure Regulation (EMIR) came into force in 2012, for example, the European Securities and Markets Authority has not granted equivalence to any of the CCPs supervised by the US Securities and Exchange Commission. Switzerland’s stock market equivalence was withdrawn from July 2019. It remains to be seen if the EU will adopt a different approach in its future relations with the UK.

For certain regulatory topics where a level of coordination between the EU and UK is particularly important, a non-binding formal discussion forum to keep UK authorities engaged in some form in the EU legislative process – but without the ability to oppose or modify rules – could be used to avoid unintended consequences, including for the EU and its industry participants. UK authorities have extensive expertise and experience that will be useful in framing future regulations. In late March 2021, it was announced that the EU and the UK were discussing the creation of a joint forum that would meet at least twice a year in order to discuss issues related to financial services.

Regulatory fragmentation is a major source of complexity and costs. Many market participants in the European Union and UK will be hoping the future emphasis is on promoting areas of common ground.