Good News on International Harmonization: CFTC and European Commission Strike Agreement on Equivalence for CCPs

February 17, 2016

The US Commodity Futures Trading Commission (CFTC) Chairman Timothy Massad and the European Commissioner for Financial Stability, Financial Services and Capital Markets Union, Jonathan Hill, in a joint statement, formally announced the long-awaited harmonization of requirements for central clearing counterparties (CCPs) between the United States and the European Union.[1]  This agreement will resolve issues regarding whether the European Union will recognize US CCPs and whether the CFTC will find comparability for EU requirements for CCPs.  Without this equivalency determination, US CCPs would not be able to clear over-the-counter (OTC) derivatives in Europe and EU firms would have likely stopped clearing at US CCPs to avoid significant capital penalties for using a "non-qualified" CCP.  Such a result could have led to fragmentation and decreased liquidity in the derivatives markets. 

When implemented, the agreement will have the effect of permitting (i) EU firms to do business with US CCPs that comply with CFTC requirements and (ii) US firms to do business with EU CCPs while complying with corresponding EU requirements.  The agreement makes clear that it is only relevant to the CFTC’s requirements for derivatives clearing organizations (DCOs) and does not apply to the US Securities and Exchange Commission’s requirements for "clearing agencies," which will continue to be treated as a separate and distinct regulatory regime. 

While this announced agreement is welcomed relief to market participants to help ensure a level playing field between the United States and European Union, the agreement must still be formalized through each respective jurisdiction’s equivalency and comparability determination processes.  Both Chairman Massad and Commissioner Hill noted that there will be concurrent processes that "will be put into place as soon as practicable."[2]  Because the first phase of clearing obligations for certain interest rate derivatives under the European Market Infrastructure Regulation (EMIR) is set to take legal effect on June 21, 2016, the European Commission Services[3] and the CFTC noted their anticipation that CFTC registered CCPs will be in a position to be recognized by that date.[4]

Prior to the announcement, market participants in the United States and the European Union cited to significant hardships to business and commerce should regulations divide CCP services.  Disparities in regulation had the potential to fracture the marketplace as many EU firms would likely have decided to stop clearing at US CCPs to avoid significant increased costs and to protect against legal and regulatory uncertainty and operational risk, and US customers would likely have faced reduced counterparty selection.  This fragmentation had the potential to lead to less competition, increased costs, and serious liquidity concerns.  In addition, many market participants, as well as the regulators,[5] noted the significant possibility of regulatory arbitrage (e.g., with respect to initial margin and capital), which would further increase costs and impact markets. 

The European process to implement the agreement is a multi-step endeavor.  First, the European Commission must propose an equivalence decision with respect to US CCPs and Member State authorities must vote on the proposal in the Europeans Securities Committee.  Once the equivalence decision is adopted, the European Securities and Markets Authority (ESMA) can recognize US CCPs serving EU firms.  In particular the Joint Statement noted that an equivalence decision will examine US CCPs’ internal rules and procedures to ensure:

1. the collection of initial margin is sufficient to take into account a two day liquidation period for proprietary positions in exchange traded derivatives; 
2. initial margin models include measures to mitigate the risk of procyclicality; and  
3. the CCP maintains ‘cover 2’ default resources.[6]

The Joint Statement also explains that these conditions will not apply to US agricultural commodity derivatives traded and cleared domestically within the US.[7]  This is effectively a carve-out that says that EMIR standards do not apply to the clearing of US agricultural commodity derivatives.

Once ESMA recognizes a US CCP, such US CCP may continue to provide services in the EU by complying with CFTC requirements.  Further such recognition will cause the US CCP to be a qualifying CCP for the purposes of the EU Capital Requirements Regulation.

The US process requires that the CFTC staff propose a determination of comparability for EU CCP requirements, so that EU CCPs serving US clients may continue to operate in compliance by observing EU regulations.  It remains unclear whether or not there will be a comment period. Chairman Massad helpfully noted that he believed that there was ample basis to find equivalency.[8]  However, it should be noted that the Joint Statement says that the CFTC staff proposed determination will conclude that "a majority of EU requirements are comparable to CFTC requirements" which begs the question "which requirements are not comparable?"  In addition to formal recognition of substituted compliance, the CFTC has also announced that it intends to streamline the US registration process for EU CCPs.  This is important as, an EU CCP that wishes to offer its services to US customers must be dually-registered with the CFTC as a DCO (or agree to some other arrangement (e.g., an exemption) with the CFTC).

Some related issues addressed in the Joint Statement include: 

1. EU Equivalence Decision of US Trading Venues.  The Joint Statement explained that "the European Commission will shortly propose the adoption of an equivalence decision under EMIR to determine that US trading venues are equivalent to regulated markets in the EU, providing a level playing field between EU and US trading venues for the purposes of the MIFID I framework."[9]  This is a significant development that is not related to clearing, but rather trade execution.  ESMA has explained that any exchange-traded derivatives contracts executed on non-EU exchanges that are not recognized as equivalent would be treated as OTC derivatives and, if not hedging, would count towards the notional amount for determining the clearing threshold calculations under EMIR.  Without such an equivalence determination, certain end-users may unnecessarily be treated as NFC+s and may lead to uncertainty in the market. 
2. Treatment During the Recognition Process.  The Joint Statement explains that during the recognition process in the European Union, CFTC-registered US CCPs will continue to benefit from relief under the Capital Requirements Regulation. 
3. Client Margining Standards.  The Joint Statement noted ESMA’s recent consultation on EU CCPs’ application of client margining standards similar to the CFTC’s requirement for US CCPs.  The current approach will not seek equivalency determinations on these standards, but the Joint Statement did note that "it is necessary to proceed rapidly with the adoption of the relevant standard" to reduce the possibility of regulatory arbitrage.[10] 
4.  EU Frontloading Requirements and EMIR.  Until formal adoption and recognition of equivalency, the Joint Statement noted that EU market participants may continue to use CFTC-Registered US CCPs to satisfy their frontloading obligations for contracts concluded on or after the February 21, 2016 implementation.  Had the agreement not been announced prior to February 21, 2016, EU firms’ would likely have stopped clearing at US CCPs.  
5. Further Harmonization.  In joint recognition, the European Commission and CFTC noted that the "derivatives markets are developing and expanding at a rapid pace across the globe."[11]  In testimony before the US House of Representatives Committee on Agriculture, Chairman Massad noted that the CFTC has been examining Asian country requirements in efforts to further find common ground; however, these efforts appear to be occurring through international workstreams and not through separate agreements with a particular jurisdiction.[12]

   [1]   Joint Statement, The United States Commodity Futures Trading Commission and the European Commission: Common approach for transatlantic CCPs (Feb. 10, 2016), available at http://ec.europa.eu/finance/financial-markets/docs/derivatives/20160210-eu-cftc-joint-statement_en.pdf  [hereinafter the "Joint Statement"].

   [2]   Joint Statement at 4.

   [3]   The European Commission Services is the umbrella term for various groups within the European Commission, one of which includes Legal Services.  See the list of European Commission Services here: http://ec.europa.eu/about/ds_en.htm. 

   [4]   Id.

   [5]   See Joint Statement at 2.

   [6]   These conditions represent certain standards for EU CCPs.  Accordingly, this means that the US CCPs must have in their rulebooks policies and procedures to address these three EMIR standards.  These are some of the conditions that ESMA will be looking for when reviewing whether the US CCP is equivalent.

   [7]   See Joint Statement at 3. 

   [8]   Hearing, US House of Representatives Committee on Agriculture, Review of the CFTC 2016 Agenda (Feb. 10, 2016), available at http://agriculture.house.gov/news/documentsingle.aspx?DocumentID=3137.

   [9]   Joint Statement at 3.

  [10]   Id. at 5.

  [11]   Id.

  [12]   Hearing, US House of Representatives Committee on Agriculture, Review of the CFTC 2016 Agenda (Feb. 10, 2016), available at http://agriculture.house.gov/news/documentsingle.aspx?DocumentID=3137.

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