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House Agriculture Subcommittee Hearing on Derivatives and Brexit

House Agriculture Subcommittee on Commodity Exchanges, Energy, and Credit

“Brexit and Other International Developments Affecting U.S. Derivatives Markets”

Wednesday, June 26, 2019

Key Topics & Takeaways

  • Regulatory Sovereignty: Duffy explained that his company would be in technical violation of U.S. law if it were to be in compliance with EMIR 2.2 because under U.S. law, the CFTC is its primary regulator. Duffy said the EU is trying to put something in place to displace the U.S. and “take over” as the regulator. Lukken explained that in the past, one regulator has deferred to another in the best interest of the clearinghouses, and this needs to be figured out now, rather than during a future systemic event.
  • Uncleared Margin Rules: Spanberger asked about the risk of uncleared swaps and how the uncleared margin rules will help mitigate that risk. Berger replied that implementing the new margin and collateral requirements for uncleared swaps was a key component of the G20 reform to the OTC derivatives markets, and companies are in the process of phasing it in through 2020. He said the industry has experienced challenges in that this last phase includes the largest number of counterparties, adding that providing additional time to phase in the buyside would be a “welcome development.”
  • Transitional Relief: Lukken explained that work has been done to ensure there is regulatory relief in place so access to clearing services is not interrupted in either scenario. He noted that although the industry has done a “good job” preparing, a hard Brexit will likely cause market volatility that could impact prices. Duffy said there will be uninterrupted access to U.S. clearing services, but the real risk is liquidity issues. Maguire added that if markets fragment due to EMIR 2.2, it will impact end users and customers for certain financial products.

Witnesses

Opening Statements

Chairman David Scott (D-Ga.)

In his opening statement, Scott said the future of international cross-border financing is critical, and that the Committee must examine Brexit thoroughly to reach a succinct understanding of how it could impact the U.S. financial industry. He noted that in 2016, the Commodity Futures Trading Commission (CFTC) reached an equivalence agreement with the European Union (EU) on the regulatory treatment of derivatives clearinghouses to ensure that both the EU and U.S. clearinghouses operate at a comparable level. He explained that now, however, the EU has passed the European Market Infrastructure Regulation (EMIR 2.2), which “unilaterally and automatically scrapped” the 2016 equivalence agreement and presents a “clear and present danger” to the U.S. financial industry, as it increases oversight of “third country” clearinghouses. Scott said this would have “significant implications” for the U.S., and that what happens in the EU during Brexit will “ripple through financial markets.”

Ranking Member Austin Scott (R-Ga.)

In his opening statement, Scott that the committee cannot address concerns about Brexit without also addressing the European Commission’s potential divergence from the “hard fought” 2016 equivalence agreement and the potential absence of international regulatory harmonization. He said overlapping rules make it more difficult for global risk markets to function the way market participants and end users need them to, and will result in inevitable conflicts, legal uncertainty and other challenges. Scott noted that such uncertainty leads to less liquidity and more risk for those driving the economy, and said regulators must work together to serve global markets, protect market participants and encourage financial stability.

Testimony

Terrence A. Duffy, Chairman and CEO, Chicago Mercantile Exchange

In his testimony, Duffy said the issues surrounding the derivatives market and Brexit are “very difficult,” noting that it affects more than farm products, but also home mortgages, 401(k)s, fuel and other services that need risk management products, and rising costs will inevitably fall on the consumer. Duffy said that following the 2016 equivalence agreement, he encouraged global regulators to avoid potential market disruption by implementing long-term solutions, and warned if they did not, regulation will artificially influence liquidity, price discovery and risk management, as well as competitively disadvantage individual markets in an increasingly competitive global marketplace. He explained that in the wake of Brexit, the EU proposed EMIR 2.2, which unilaterally amends the equivalence agreement and imposes significant new requirements in addition to those previously agreed to “without justification.” He said the ratification of the equivalence agreement reflected consensus that the U.S. and EU regulations were comparable and equivalent, yet last month the EU regulatory authority responsible for overseeing non-EU clearinghouses released a consultation recommending the implementation of EMIR 2.2 and requiring a line-by-line comparison of U.S. and EU law, “ignoring” the principles of deference and substituted compliance that the two jurisdictions previously agreed to.

Duffy continued that the European Securities and Markets Authority (ESMA) proposed to classify U.S. clearinghouses relative to their systemic relevance to the EU through a set of subjective criteria that in many cases have no nexus to the EU and are “inappropriate” tests of whether a U.S. clearinghouse has systemic importance to the EU, and that ESMA further proposed to override U.S. law and the 2016 agreement by rejecting substituted compliance for U.S. clearinghouses that they deem systemically important to the EU. Duffy explained that this proposal would demand strict compliance with the majority of the EU rulebook, effectively making ESMA, not the U.S. Congress and the CFTC, the standard-setter for U.S. clearinghouses. He said this “wholesale regulatory takeover” by the EU is inconsistent with the needs of the global financial markets, and that without deference and cooperation markets could face regulatory fragmentation, decreased liquidity, increased volatility and higher prices for market participants and consumers, weakening the stability of the U.S. financial system.

Christopher Edmonds, Senior Vice President of Financial Markets, Intercontinental Exchange

In his testimony, Edmonds said that clearing has consistently proven to be a fundamentally safe and sound process for managing systemic risk, and that observers frequently point to noncleared derivatives contracts as a significant factor in the broad reach and complexity of the 2008 financial crisis while noting the relative stability of cleared markets. He explained that the 2016 equivalence agreement promotes regulatory deference and prioritizes provisions supporting global derivatives markets, and that Brexit should have “no bearing” on these efforts. Edmonds stated that reforms to this agreement could lead to overlapping and conflicting requirements, saying this is “in no one’s best interest.” He said the “spirit of cooperation” should guide ongoing discussions on critical cross-border issues including EMIR 2.2 implementation and potential Brexit responses, and that while the policy goals of the European Commission to ensure appropriate supervision of non-EU domiciled central counterparties (CCPs) that are deemed systemically important are “completely understandable,” these goals can be achieved by ESMA employing mechanisms based on international standards. Edmonds said there should be no ambiguity about the ultimate decision-making authority as the industry cannot afford regulatory confusion during a time of stress, and that cross-border oversight and regulatory deference to home country regulators are essential to well-functioning markets.

Daniel Maguire, CEO, LCH Group

In his testimony, Maguire said both Brexit and the evolving global dialogue about cross-border regulation of clearinghouses could have ramifications on wider markets. He explained that temporary measures have been put in place to avoid disruption for interest rate swap markets regardless of the political outcome of Brexit, and that to mitigate significant market disruption and stability risk in the event of a “hard Brexit,” the European Commission and the UK government collaborated to install temporary contingency measures that would allow EU participants to continue to have access to UK clearinghouses and global liquidity. Maguire said that the future architecture of global derivatives markets must “at all costs” avoid unnecessary fragmentation by maintaining regulatory and supervisory cooperation and deference. He also noted the importance of allowing systemically-important derivatives clearing organizations (DCOs) to deposit U.S. dollars in a U.S. central bank account regardless of their domicile for safekeeping of customer margin. He urged the Committee and U.S. financial regulators to further evaluate the important financial stability role that central bank deposit accounts play for systemically-important DCOs.

Walt Lukken, President and CEO, Futures Industry Association

In his testimony, Lukken said that open markets allow people to access hedging vehicles around the world, which is most important to farmers, producers and manufacturers looking to hedge risk. He noted the global nature of the derivatives market, saying that global markets could not have developed as they have without a commonsense regulatory approach with international cooperation. He expressed “strong support” for the regulatory recognition and deference model that has been the foundation of the futures industry for years, but voiced concern that regulators are now moving away from this “pragmatic approach” by imposing direct authority on third country exchanges, clearinghouses and transactions. He said this divergence could lead to conflicting rules and harmful market fragmentation, and that it is “imperative” to get cross-border issues “right,” especially “with Brexit looming.”

Stephen Berger, Managing Director, Global Head of Government and Regulatory Policy, Citadel LLC, on behalf of Managed Funds Association

In his testimony, Berger said central clearing has benefited the derivatives markets by reducing systemic risk, increasing investor protection and promoting transparency and competition. He said coordination between the U.S. and European regulators on clearing implementation is “crucial” to its continued success and efficacy, but the UK’s impending withdrawal from the EU introduces “new complexities” for global regulatory coordination. He said the current U.S.-EU cross-border framework relies on the regulatory tools of substituted compliance, equivalence and deference between comparable regulations, and the new EU powers granted by EMIR 2.2 could affect that framework. He continued that any deterioration in U.S.-EU cooperation could jeopardize cross-border clearing, which in turn could fragment the derivatives markets.

Question & Answer

Regulatory Sovereignty

Austin Scott asked about regulatory sovereignty and the dangers of infringement on the CFTC’s ability to regulate U.S. domiciled entities. Duffy replied that his company would be in technical violation of U.S. law if it were to be in compliance with EMIR 2.2 because under U.S. law, the CFTC is its primary regulator. He said it “doesn’t make sense” for his company to simply cease doing business in Europe, and that the duplicate costs associated will ultimately be passed down to the consumer, calling it “very damaging.”

In response to a question from Rep. Rick Crawford (R-Ark.), Duffy said the EU is trying to put something in place to displace the U.S. and “take over” as the regulator. Lukken explained that in the past, one regulator has deferred to another in the best interest of the clearinghouses, and this needs to be figured out now, rather than during a future systemic event.

Berger explained that the MFA is a proponent of central clearing of derivatives because it mitigates systemic risk, provides enhanced investor protection and provides a more transparent and competitive market. He said that the buyside wants the ability to conduct investment and hedging activities in the largest possible liquidity pools with the most diversity of other participants to get the best pricing for the customers they are investing on behalf of, noting the importance of access to clearinghouses no matter where they are located. He said it is important for regulators to work together to ensure that access is unimpeded and the liquidity pool is not fragmented.

Transitional Relief

Rep. Abigail Spanberger (D-Va.) asked about possible outcomes for constituents as a result of a “hard” or “soft” Brexit. Lukken explained that work has been done to ensure there is regulatory relief in place so access to clearing services is not interrupted in either scenario. He noted that although the industry has done a “good job” preparing, a hard Brexit will likely cause market volatility that could impact prices. Duffy said there will be uninterrupted access to U.S. clearing services, but the real risk is liquidity issues. Maguire added that if markets fragment due to EMIR 2.2, it will impact end users and customers for certain financial products.

Uncleared Margin Rules

Spanberger asked about the risk of uncleared swaps and how the uncleared margin rules will help mitigate that risk. Berger replied that implementing the new margin and collateral requirements for uncleared swaps was a key component of the G20 reform to the OTC derivatives markets, and companies are in the process of phasing it in through 2020. He said the industry has experienced challenges in that this last phase includes the largest number of counterparties, adding that providing additional time to phase in the buyside would be a “welcome development.”

Systemic Importance

Rep. Sean Patrick Maloney (D-N.Y.) asked about the EU regulators’ power to designate third country clearinghouses as systemically important. Duffy called it a “regulatory grab,” saying the EU is looking to “become the regulators of the world.”

Congressional Action

David Scott asked what Congress can do to address these issues and ensure U.S. market participants are not inhibited by Brexit. Edmonds said “anything to increase certainty is a must,” adding that promoting equivalence is important. Maguire said that there is a long-established and well-working relationship between the U.S. and UK financial systems and markets, and it is important to “lean on that” when discussing how equivalence and deference can work going forward. Lukken urged Congress to utilize its oversight powers, send a letter to ESMA expressing the Committee’s views, and to give the new CFTC commissioner room to negotiate with the Europeans.

For more information on this hearing, please click here.