The United Kingdom became the first European Union member state ever to take legal proceedings against the European Central Bank (ECB) with its Sept. 14 lawsuit challenging a proposed rule that would threaten London’s status as a trading center.
What’s more, the battle is taking place against the backdrop of political tension across the EU, as the European Parliament is on the verge of finalizing the European Market Infrastructure Regulation (EMIR), which sets clearing and reporting requirements for over-the-counter (OTC) derivatives trading. EMIR is part of a broader push, in response to the financial crisis and ensuing G20 agenda, to place EU financial services reform legislation on par with the U.S.’s Dodd-Frank Act.
The U.K.’s lawsuit, filed with the European Court of Justice, comes in response to a policy paper the ECB published on its website in July. In the paper, the ECB set forth its intentions to ban clearinghouses outside the eurozone if the clearinghouse had €5 million or 5 percent of the market share of a euro-denominated financial product. That includes OTC derivatives trading, so it’s understandable that the proposal sent shockwaves through the U.K. given London is host to 40 percent of global OTC derivatives trading and 75 percent of Europe’s. A substantial part of that market is euro derivatives trading, so the location requirement could sound the death knell for London’s market dominance.
“It’s really an unfortunate turn of events,” says Ed Parker, head of the Derivatives & Structured Products Practice at Mayer Brown in London. “It seems to me it’s something that’s forcing the clearinghouses to be established in the eurozone, and it seems to be more of an anti-competitive business-protection move than anything to do with the safety of the markets.”
In the ECB’s July 5 policy framework, the Central Bank explains that proper oversight of clearing and settlement systems is essential for the industry’s own proper functioning to preserve the general stability of financial systems.
It then outlines its belief that the euro financial market infrastructure should be located in the eurozone. “As a matter of principle,” the paper reads, “infrastructures that settle euro-denominated payment transactions should settle those transactions in central bank money and be legally incorporated in the euro area with full managerial and operational control and responsibility over all core functions for processing euro denominated transactions, exercised from within the euro area.”
The enforcement of such a rule would be disastrous for London.
“Any implementation of the ECB policy would be immensely difficult and time consuming; it is not as simple as saying, ‘Let’s move the clearinghouse from London to the eurozone,’ and expecting it to be done the next week,” says Harry Eddis, counsel in the financial regulation group at Linklaters in London.
The impact of the ECB rule would come on top of further regulatory uncertainty for the financial sector.
“There is currently a great deal of uncertainty on the extra-territorial reach of Dodd-Frank, EMIR and MiFID II, and the implications of the ECB policy statement merely add fuel to that particular fire,” Eddis says.
Lawsuit for London
To avoid such a scenario and protect London, the U.K. is challenging the proposal on the basis that infringes on cross-border business across the EU and restricting the free movement of capital and services. A statement from a U.K. treasury secretary makes clear that the ECB should take the lawsuit seriously: “The government wants to see this resolved swiftly and without involving the courts, but if necessary will not shy away from continuing legal action to make sure there is a level playing field across the EU for British businesses.”
It’s widely expected that some sort of agreement or settlement will render the U.K. claims unnecessary.
“There’s no doubt that the ECB would not have expected the U.K. government to take what was a fairly aggressive approach by issuing proceedings,” says Michael McKee, a partner in DLA Piper’s Financial Services Regulatory Team in London. “Whether they will have the appetite to fight the U.K. in court, I’m not sure. I would think that in the current difficult climate of sovereign debt issues, the ECB will at least step back from this particular initiative because they have a lot of fires to fight elsewhere.”
It’s also impossible to view the U.K.-ECB clash without considering that the EU just issued a final draft of EMIR.
One of the central debates over EMIR has pitted the U.K. against other member states such as France and Germany, which want bigger shares of the financial market, over the control and authorization of clearinghouses. So some see the ECB initiative as a backdoor way of achieving what some have fought for in the legislation—and the lawsuit as a showy gesture by the U.K., in response to criticism that it hasn’t stood up for its financial services sector.
On Oct. 4, the U.K. won an important concession in EMIR negotiations with the insertion into the legislation of language that prohibits the discrimination against any member state as a venue for clearing services. Further, EMIR now specifies that the authorization of a clearinghouse can only be blocked with a near-unanimous vote among the relevant committee of the European Securities and Markets Authority.
“This now means that clearinghouses in the U.K. can be authorized without the fear that France, Germany or other member states will easily overrule such an authorization,” Parker says. “Since London is home to LCH.Clearnet, and more recently CME Group and IntercontinentalExchange clearinghouses, the U.K. government may now be less concerned that these entities will be barred from functioning here.”
It’s still possible that the ECB will attempt to follow through with enforcement of its eurozone requirement.
“With the euro under a lot of pressure, as you can imagine, the ECB wants to have as much authority and as much control as it possibly can,” McKee says. I wouldn’t rule out other attempts to extend its control through other proposals.”