Europe, Clearing Equivalence, and the SEC

By Miles Reucroft. Thomas Murray

Originally published on Tabb Forum

The world’s largest equity derivatives clearinghouse, OCC, has been placed on CreditWatch with a negative outlook by S&P, damaging the clearinghouse’s ability to comply with European clearing standards – something that will be an issue should the SEC and European Council reach equivalence over their clearing rules. If OCC cannot comply with the equivalent rules, European banks will face significantly higher capital requirements to clear at OCC, severely disrupting the U.S. options market.

On May 17, OCC, the U.S. clearinghouse that is the largest equity derivatives clearinghouse in the world, was placed on CreditWatch with negative implications by the ratings agency S&P.

This has ramifications for OCC in its attempts to become compliant with European clearing regulations.

Further, in its rating of OCC, S&P observes that:

“OCC lacks the pool of liquidity resources that would enable it to settle, at a 99 per cent confidence level, the securities transactions of the largest two Clearing Members (should they default at the same time). This is in contrast to the ‘Cover 2’ minimum standard that European peers must meet.”

In other words, OCC is not in a position to comply with European clearing standards.

The clearinghouse landscape in the U.S. is regulated by two entities: the Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC).

The European Council (EC) reached equivalence with the CFTC in March of this year. The lengthy negotiations between the two parties resulted in a lot of column inches; talks between the EC and the SEC have been less prominent, but are no less important.

The EC repeatedly postponed its capital requirement deadline as talks with the CFTC were ongoing. The current deadline is June 15, although the EC has said it will delay the implementation date another six monthsas it negotiates with the SEC. Eventually, however, European banks will have to start holding increased capital against trades conducted at foreign clearinghouses.

That is, unless the clearinghouse is deemed equivalent to European clearinghouses, is approved by the European Securities and Markets Authority (ESMA) and becomes a Qualified CCP, or QCCP. All CFTC-regulated clearinghouses, including ICE and CME, are now deemed to be QCCPs in Europe; therefore, European banks need not hold added capital against trades conducted at these venues.

Should the SEC and EC not reach an equivalence agreement by June 15 (now likely Dec. 15, 2016), however, then European banks will have to hold significantly more capital against trades conducted at OCC – this would be disruptive to market activity, since OCC has a monopoly on clearing equity options in the U.S.

If the capital rules come into effect in Europe and OCC finds itself as a non-QCCP, it has estimated that European participants will have to hold some $5.25 billion in extra capital to cover trades conducted at OCC.

During negotiations between the EC and SEC, CME, the U.S. clearinghouse, estimated that capital charges would increase 30-fold if equivalence could not be found.

The EC/SEC negotiations are also of importance to DTCC, the other major U.S. clearinghouse that is regulated by the SEC.

The repeated postponements to the implementation of the new capital rules by the EC during negotiations with the CFTC suggest that the same outcome is quite likely here, too. But the S&P report on OCC states that it, “lacks the pool of liquidity resources that would enable it to settle, at a 99 per cent confidence level, the securities transactions of the largest two Clearing Members.” Equivalence matters not a jot – OCC is not in a position to become a QCCP.

In its announcement on May 17 stating that OCC was being placed on CreditWatch with a negative outlook, S&P again observed that OCC is operating on a “Cover 1,” rather than a “Cover 2,” basis. With the European capital rules less than a month away, OCC is not in a position to comply with European standards.

S&P also observes that OCC’s loss-absorbing standpoint is “weaker” than “most European and some other U.S. clearinghouses.” ICE and CME are noted as observing the “Cover 2” level.

Is the SEC slowing negotiation with the EC in order to enable OCC to rectify this? Action has certainly been slow – this has been a red flag on the horizon ever since the respective clearing rules of the U.S. and Europe were drawn up.

The potential downgrading of OCC’s credit rating is another thorn in its side here. OCC has a major credit line from a nonbank institution, CalPERS. S&P states that, “We could lower the rating on OCC by one notch (it is currently AA+) if OCC does not move to a ‘Cover 2’ from a loss-absorbing perspective.”

OCC can call upon a credit line of $2 billion from CalPERS in the event of a default by a major Clearing Member or Clearing Members. Negative activity on its credit rating, however, will impact the cost of this credit line to OCC.

CalPERS is a major U.S. pension fund. That in itself makes this situation somewhat curious: Why is a fund underwriting a CCP? It suggests that OCC was unable to secure the necessary provisions from a bank.

OCC is compliant with all regulations hanging over it at present. Should the SEC reach clearing equivalence with the EC by June 15, however, it will find itself as a non-QCCP. The questions for the regulators then is whether the capital rules should be delayed once again, or the equity options markets should face severe disruption.