Over the Counter Derivatives, Central Counterparties and Trade Repositories (Amendment, etc., and Transitional Provision) (EU Exit) (No. 2) Regulations 2019

Tuesday 1st October 2019 Lords Chamber

Motion to Approve

17:05

Moved by

[Lord Bethell]

That the draft Regulations laid before the House on 24 July be approved.

[Lord Bethell (Con)]

As the House will be aware, the Government had previously made all necessary legislation, under the EU withdrawal Act, to ensure that, in the event of a no-deal exit on 29 March 2019, there was a functioning legal and regulatory regime for financial services from day one. Following the extension to the Article 50 process, new EU legislation will become applicable before 31 October and, under the EU withdrawal Act, this new legislation will form part of UK law at exit. Further deficiency fixes are therefore necessary to ensure that the UK’s regulatory regime remains prepared for exit. The approach taken in this instrument aligns with those financial services exit statutory instruments already approved by Parliament, providing continuity by maintaining existing legislation at the point of exit, but amending where necessary to ensure that it works effectively after exit.

I shall turn to the substance of the instrument. The European Markets Infrastructure Regulation, usually referred to as EMIR, implements the G20 Pittsburgh commitment from 2009 to regulate over-the-counter derivative markets in the aftermath of the financial crisis. EMIR was reviewed by the European Commission in 2015-16, resulting in an update known as EMIR REFIT. EMIR REFIT makes a series of technical changes so that the framework for over-the-counter derivatives, usually referred to as OTC derivatives, applies in a more proportionate way. EMIR REFIT focuses on users of OTC derivatives. It does not make significant changes to the rules for central counter- parties—CCPs. In particular, it provides exemptions from the requirement to clear trades in those derivatives through a CCP, because clearing is not always appropriate for all firms.

As the House will be aware, earlier EU exit legislation was used to address deficiencies in EMIR, as it will form part of UK law at exit. This instrument addresses new deficiencies which will arise as a result of the recent amendments made to EU legislation by EMIR REFIT, which came into force on 17 June 2019. After exit, the UK would be outside the EEA and outside the EU’s legal and supervisory framework for financial services. The EMIR framework that will form part of UK law at exit therefore needs to be updated to ensure that these new provisions continue to work effectively.

This instrument will ensure continuation of the new provisions introduced in EMIR REFIT and will transfer new EU functions to the appropriate UK authorities. Many provisions in EMIR REFIT will continue to work effectively at exit without significant amendments—for example, the exemption for small financial counterparties from the requirement to clear trades through a CCP.

However, there are two key deficiency fixes in this instrument which are necessary to ensure that EMIR REFIT is workable in a UK context. First, this instrument ensures that UK pension schemes will continue to be the exempt from the requirement to clear trades through a CCP. This is an important provision for industry and consumers; an exemption for pension schemes is needed because there is currently no approach to clearing that works without subjecting pension schemes to disproportionate cost, particularly the requirement to pay margin to the CCP. These additional costs would ultimately undermine the ability of pension funds to meet their obligations to pension holders. In the EU, EMIR REFIT currently includes a pension scheme clearing exemption which will last anywhere between two and four years. This instrument provides greater certainty and stability by ensuring that there is no ambiguity about the length of the extension. That extension will now last the full four years in the UK.

This fix is appropriate given the size and nature of the UK pension schemes, the vital role they play in pension provision and their crucial position as long-term investors in the UK economy. This instrument will provide the time to find a solution which balances the interests of pension schemes and CCPs, which will be particularly challenging in the UK context. The instrument enables the Treasury to extend the pension scheme exemption further, for up to two years at a time, if no appropriate solution for the UK market has been found. It also ensures that EEA pension schemes will continue to be exempted in the UK. This means that UK banks will still be able to trade derivatives with EEA pension schemes without using a CCP. Her Majesty’s Treasury committed to this action on 21 February to avoid disruption to UK businesses offering derivatives to EEA pension schemes.

Secondly, the instrument transfers the function to suspend the clearing obligation from the European Securities and Markets Authority and the European Commission to the Bank of England. In EMIR REFIT, ESMA can recommend that the European Commission suspend the clearing obligation in three-month increments for up to 12 months. We believe that the Bank of England is the most appropriate UK authority for this function, in line with the responsibilities that Parliament has already conferred on the Bank for financial stability and CCP supervision. The Bank of England must secure the consent of Her Majesty’s Treasury and inform the Financial Conduct Authority if it needs to suspend the clearing obligation in the UK. The Bank may decide to issue a suspension lasting for any period up to 12 months. Such flexibility will enable the Bank to reduce uncertainty for globally significant clearing members and clients based in the UK in the unlikely event that a suspension is necessary. Finally, this instrument ensures that all references to EMIR are up to date on exit day so that references in UK legislation after that point will refer to the right version.

The Treasury has been working closely with the Bank of England and the Financial Conduct Authority to prepare this instrument. We have also engaged the financial services industry extensively on it. The Treasury published the instrument in draft on 24 July ahead of the Summer Recess, to maximise transparency to Parliament and industry.

This legislation is necessary to ensure that EMIR legislation continues to function effectively in the UK from exit. In particular, it will ensure that UK firms are able to use the new provisions on proportionality introduced by EMIR REFIT, and that the Bank of England is able to take necessary action to safeguard financial stability where necessary. I hope that your Lordships will join me in supporting these regulations. I beg to move.

[Baroness Bowles of Berkhamsted (LD)]

My Lords, I must declare my interest as a director of the London Stock Exchange plc and Prime Collaterised Securities ASBL, as these measures may affect parts of the businesses with which I am involved. As I am sure many noble Lords already know, I also have a personal affinity with these matters having either negotiated them or left them on my to-do list for the European Commission when I ceased to be chair of the Committee on Economic and Monetary Affairs.

On the OTC derivatives and, in particular, the pension funds exemption, I can add a little history. It was a UK issue that came up rather late in the day, so it had to be pulled out of my magic negotiating bag during trialogues to fix it; and because it was a UK issue, there were not necessarily a lot of people who wanted to fix it. One thing that helped me on my way was that I managed to mobilise the defined benefit pension funds that had been taken over by German businesses when they took over some of the car industry. They suddenly decided that they had a workforce that might be concerned. That is just one of the levers that I managed to pull.

17:15

I am pleased that the extension is there. I do not mind the fact that it is not being done in increments, because I remember pressing that there should have just been an exemption—full stop—but there was a lot of concern at the time. The risk is still there, if you assume that there is risk with OTC. Of course, the thinking at the time was to exempt nothing, which is why there had to be the subsequent refit, among other things, to take out some of the smaller companies and so on. The way it was done—that it could be two years at a time—was so that there would be some incentive to find a solution. But, realistically, will any solution ever be found? If they are not geared up now to be able to post collateral as cash without a lot of expense, will that happen in the future, or is the way that clearing and collateral are received by the clearing houses likely to change? In these four years, are solutions actually going to be sought, or will this just be left on the shelf with the assumption that there will eventually be a permanent exemption? In a sense, it is said that, along with those other aspects of proportionality, that should not be covered. If a solution comes along in that four-year period, would it be applied? Is there any way that it could be cut short, especially if that was being done elsewhere?

There is a similar issue over time periods. Maybe here it is a little more relevant when it comes to the suspension of the clearing obligation in Part 4, where the Bank of England, with the consent of the Treasury, can suspend it for various good reasons, and there is no reason why there should not be a suspension. Personally, I can buy the idea of, instead of doing it in nibbles, giving large businesses time to plan and then saying, “Okay, we will go straight in and give the one-year extension”. I can see the reasoning for that. I did not have time to remind myself of the full contents of EMIR, but the Bank is still limited to setting the period of suspension at no more than 12 months. Can it do that more than once? If, under Article 6a(1)(a), it is a specific class of OTC derivatives that are no longer suitable for central clearing in accordance with the criteria in Article 5, that seems permanent. Finding things appropriate for clearing has been a function that has gone on as ESMA has made the decisions. If you get to a decision that says, “Actually, we want to reverse that”, then a one-year suspension is not long enough. I am just curious about what happens in that circumstance. Does it mean that another decision and change of law would be brought in, or, if I bothered to drag it out and have a look, would I discover that it was covered by Article 5 of EMIR? Just reading what is here, it looks like something is no longer appropriate for clearing, but it looks like it is going to be no longer appropriate for only 12 months, unless we can somehow fix that or keep on extending it. Is there any enlightenment there?

Finally, one other thing jumps out at me. I have looked at a lot of statutory instruments over the last many months, in the Secondary Legislation Scrutiny Committee and in the Moses Room, where we read the same thing about the close relationship on financial services that the UK seeks. That is looking ever less likely—in fact, I think it has been abandoned. To be honest, I never thought it was all that likely. It is not realistic to keep reiterating the same text in the Explanatory Memorandum when we have even had a change in Prime Minister and it looks ever more likely that there will be no deal, and certainly no financial services deal. I do not feel that the Explanatory Memorandum and the strength with which this close future relationship is iterated reflects the status quo at the time we are actually having to deal with this statutory instrument. A little rewriting of it to more genuinely reflect the situation before us would be appropriate, otherwise, I think it is a bit dishonest. Maybe that is not a word I am allowed to use, but I am sure that Hansard can find the right word. I think it is slightly misleading.

With that, I have no objection to this statutory instrument, because it is obviously a useful and necessary thing that needs to be continued for the benefit of the UK financial services industry.

[Baroness Kramer (LD)]

My Lords, I agree with my noble friend Lady Bowles that the Explanatory Memorandum needs to be updated to reflect the current circumstances and the current attitude towards our future relationship with Europe. Frankly, that is necessary in order to be fair to the industry, which will be reading all this with a great deal of attention, because the various aspects of this statutory instrument obviously have a very big impact on its businesses, what they are able to do and how they need to adjust to cope with any kind of Brexit, should it happen. I want to pursue a slightly different direction from my noble friend, however, and ask about the divergence that seems to be embedded in this statutory instrument. I ask for a very particular reason: your Lordships will be well aware that the London Clearing House is now well set up in Paris as well as in London; that there has been a major shift by many of the big banks to centre a lot of their trading activity through Paris; and that undoubtedly, should Brexit happen, that will be enhanced and there will be increased activity in Paris covering essentially the same business range when it comes to derivatives and over-the-counter derivatives. There will be an equivalent central counterparty functioning almost as a rival body, so the embedded divergence in this statutory instrument becomes important, perhaps as a bellwether for the future, and I would like to probe the Minister on it.

It strikes me, first, that paragraph 2.8 explains:

“Some of the provisions of the REFIT amendment to EMIR do not become applicable until after 31 October 2019 … Therefore, this instrument does not make amendments to those provisions”,


to incorporate those changes, as it were. I would love to know the content and significance of those amendments and how they will impact the shape of the industry. The CCPs or the regulators will need to behave in a different way if we have an embedded divergence that would come into effect in a matter of days. I would find that information rather helpful and perhaps the Minister would be kind enough to enlighten me.

That brings me to paragraph 2.16. As my noble friend Lady Bowles said, it states:

“EMIR, as amended by REFIT, allows the Commission to suspend the clearing obligation for up to twelve months in three-month increments”.


The new equivalent power, to be handed to the Bank of England, chooses to allow the Bank to suspend for up to 12 months—in other words, not following the pattern of three-month increments. It sounds like a minor difference, and it possibly is, which raises the interesting question: why choose to embed a divergence? Could it leave us in the rather peculiar situation that one CCP in Paris—ironically, under the same ownership as the CCP in London—could be operating under different rules when it comes to suspending obligations? Is that a situation we want to see? Is this to be an area of competitive rivalry? What will the impact be? It seems to me that encouraging companies or funds to play regulatory arbitrage is never the healthiest strategy to pursue. Perhaps the Government could explain, because I would just like to understand it better.

There is another odd area where apparently, inconsistency will remain in the future. Paragraph 2.17 explains that within the European Union,

“Any suspension of the clearing obligation that impacts classes of derivatives with a trading obligation must result in the trading obligation also being suspended to avoid a conflict”.

That seems entirely logical, but apparently that is not going to carry over into the UK. There will be no automatic suspension of the trading obligation. It sounds like the FCA will then be responsible and the Bank will then have to notify the FCA of its intention to make the clearing obligation suspension, rather than the link being an automatic one. It strikes me as cumbersome and inefficient and I wonder why it is being chosen.

Perhaps the Minister, as he finishes, will just explain this. Although the embedded divergencies are minor, they certainly can be played by financial institutions. Given the rapid growth of Paris, picking up business that was almost exclusively being done through London, it is probably best for this House to understand.

[Lord Davies of Oldham (Lab)]

My Lords, I apologise to the noble Lord, Lord Bethell, and to the House for having missed the first couple of minutes of his significant words, but I think I could pick up from the way in which he developed his theme exactly the position of the Government on this complex area. The Minister’s answers to the questions and anxieties of the two noble Baronesses from the Liberal Democrat Benches will certainly help us to understand his position.

I hope that the noble Lord is enjoying his Front-Bench debut on the EU exit SIs. It has been a fairly onerous task. As far as my own contribution is concerned, my noble friend Lord Tunnicliffe, who normally joins me in economic debates, is unfortunately not able to be here today, otherwise he would have added to the absolutely excellent work that he has done over a long period of time in successive discussions on these almost endless SIs. However, I thought it right that he should have a certain amount of time off, and he has gone to an event at which his wife is a star figure who is being given an award, so I am not surprised that he is on duty there rather than here today. However, he has had the advantage of having scrutinised about 50 of these Treasury SIs—and of course the Minister will have taken steps to catch up with all that.

This instrument makes several changes to both the Financial Services and Markets Act 2000 and relevant pieces of retained EU law to ensure consistency with the UK’s obligations under the EMIR REFIT regulation, which came into effect earlier this year. We do not regard these changes as controversial, and therefore we support the instrument. However, we will look for elucidation and clarification of certain parts of how it will work. I am grateful to the noble Baronesses who have already spoken for having identified important areas in which the Minister needs to respond.

17:30

As the Explanatory Memorandum notes, some parts of the REFIT regulation will not technically form part of retained EU law on the proposed exit day, as they will not have yet come into force across the bloc. Can the Minister confirm whether the department has considered the merits of applying these changes regardless of that fact? Certainly, both the noble Baroness, Lady Bowles, and the noble Baroness, Lady Kramer, sought an update of the Explanatory Memorandum, and the Minister will be fully charged of that. Of course, on this issue of divergence, as each week goes past we are much more aware of the extent to which alternatives are being made by banks to locate themselves within the European Union while at present they exist in the United Kingdom, and it is terribly important that we understand how these divergences will work under the new regulation.

In the Minister’s opinion, would the Government’s failure to implement these changes introduce any risk that, in the event of a no-deal Brexit and the UK then seeking an equivalency ruling from the Commission, we would not be deemed to be at an appropriate level of regulatory alignment? That is a hypothetical question, posed against an uncertain situation, and I almost feel like apologising to the Minister for asking such a tangled question. However, it is a fact of the matter that we have to consider, and I wonder what the Minister’s response to that point will be.

We found a further part of the Explanatory Memorandum particularly interesting. Paragraph 2.8 talks of making corrections to retained EU law “if” the UK were to leave the EU on 31 October. I know that this instrument was laid in July, and I know also that some Conservative Members of the European Parliament are advertising for staff in Brussels with a starting date of 1 November. So they at least either know what is going on or are taking an interesting plunge into the unknown. However, I wonder whether, despite the rhetoric of the Prime Minister, common sense is prevailing and the Government accept that a no-deal exit would be profoundly damaging to the economy. I sincerely hope that the Minister can confirm that that is the case.

While the Chancellor claims to have a plan in place to mitigate the economic effects of no deal, we know from numerous economic analyses that there would be a significant shock. The Yellowhammer documents confirmed our worst fears—that this shock would be disproportionally felt by the most vulnerable in our society. I therefore urge the Minister—I hope he will respond to this plea—to convey to his colleagues the previously stated view of this House that the Government must avoid a no-deal exit at all costs.

[Lord Bethell]

My Lords, I express my thanks for an informative debate on this technical but incredibly important measure. I give particular thanks to the noble Baroness, Lady Bowles, who gave us a good trot around the history of some of the regulations and described in very honest terms her central role in the background of some of these instruments. I remember well her front-line role in fighting for Britain’s interests in this matter during a very difficult period.

I start by answering her question about whether the clearing suspension can be extended. The instrument allows the Bank of England to suspend the clearing obligation for up to 12 months, with the consent of the Treasury. This means that the Bank can decide to issue a suspension lasting for any period up to 12 months, based on its assessment of the situation. For instance, it may determine that a suspension for six months is the best option, but the suspension cannot be extended. However, if the conditions of the suspension of the clearing operation continue to be met, we would expect the Bank to institute a new suspension if necessary, which would again require the consent of the Treasury.

The question was asked: can the pension scheme clearing exemption be renewed or extended? This instrument allows the Treasury to extend that exemption for up to two years at any time by regulation, if no alternative can be found for the UK market. Importantly, this means that it could be renewed if no solution were to be found.

Will there be a permanent solution to the pension scheme exemption? Currently, requiring a pension scheme to clear trades in a CCP can lead to disproportionate costs, especially the requirement to pay margin on CCP in cash. A technical solution would address this problem: for example, it would involve finding a way for the pension scheme to meet its obligations to the CCP without turning long-term assets into cash. Any solution must not pose a risk to the CCP. However, currently the EU has been unable to find a solution which accomplishes that, and the Government will continue to work with UK CCPs and pension schemes on that important question. This will ultimately be decided according to what the technical solution will look like.

The noble Baronesses, Lady Bowles and Lady Kramer, and the noble Lord, Lord Davies, all raised questions about the Explanatory Memorandum. Their points were well made and the concerns behind them are completely understood, but I reassure the House that the Government remain utterly committed to doing a deal. However difficult that may seem, that remains the commitment, and that includes a deal on financial services. The Explanatory Memorandum continues to reflect the Government’s policy, but of course we should be ready for all scenarios, which is why we are here today.

The noble Baroness, Lady Kramer, raised an important point on the question of divergence. I should like to reassure her on that. This SI aims to ensure continuity—that is its whole ethic and philosophy—and consistency with EU laws. This is not about divergence. I remind the House that the SI has been warmly welcomed by business after a long period of consultation, and if concerns about divergence were still outstanding, I am sure the industry would have voiced them.

The noble Baroness also asked about regulatory arbitrage, about which I should similarly like to reassure the House. Our onshoring approach aims to preserve existing regulation as much as possible. We also want to maintain maximum supervisory co-operation with the EU to avoid regulatory arbitrage of any kind. She also asked whether the trading obligation will be suspended automatically. I should like to reassure the House that in the EU, the trading obligation would not be automatically suspended. For the UK, we have made the trading obligation suspension automatic on suspending the clearing obligation. I hope that is understandable.

The noble Lord, Lord Davies, asked whether the Government will implement the remaining aspect of the EMIR REFIT and how that implementation would happen. The purpose of this SI is to address deficiencies that will arise in UK law if the UK leaves the EU without a deal. It cannot address aspects of the EMIR REFIT which are not in application. We are working with regulators and industry to ensure that the remaining provisions in EMIR REFIT are implemented in an appropriate manner for the UK.

In conclusion, I reassure the House that every effort has been put into the consultation on these important regulations. Industry has lent an enormous amount of support to them and they have been laid before the House for a considerable time. In that spirit, I ask the House to approve these regulations.

Motion agreed.