The impact of EMIR 3.0 on Euro swaps trading

Meridy Cleary: Hi, you're listening to Market Matters, our markets series here on J.P. Morgan's Making Sense podcast. I'm your host, Meridy Cleary, from the FICC Market Structure team. And today's episode surrounds one of the top market structure themes in the industry right now, and that's EMIR 3.0 and how these new EU clearing rules are impacting euro derivatives liquidity and trading strategies across the continent. To discuss these dynamics, I'm joined by Roxane Blanc, who is a senior rates trader based in Paris. Hi, Roxane. Thank you so much for joining me today.

Roxane Blanc: Thanks, Meridy. It's great to be here.

Meridy Cleary: So Roxane, I know that we can both agree that EMIR 3 has been quite the focus point. For our listeners who might not be as familiar, EMIR 3 is an amended version of the European markets infrastructure regulation, which in the context of the post-Brexit landscape aims to make the European Union's clearing landscape more competitive and reduce the reliance on non-EU CCPs. So to drive further euro denominated derivatives clearing activity to the EU, a key component of the rules was the introduction of an active account requirement, which has two main elements. So the first is this operational requirement, meaning that in-scope firms have to hold an open account at an EU CCP by June 24th. And the second requirement is that of representativeness. So that means that entities need to clear a portion of their in-scope derivatives through an EU CCP. So obviously this is quite a convoluted set of reforms. I think we can both agree on that. And so Roxane, from a trading perspective, why is this such a front and centre topic right now? And what does it actually mean for the market?

Roxane Blanc: Thanks for your question, Meridy. EMIR 3 has been a market structure theme for a number of years now, but as we get closer to these key implementation dates, like June 24, market participants are focused on their strategies to comply with these new sets of rules. LCH is the primary clearinghouse currently for Euro-denominated derivatives, and EUREX is the primary EU CCP, which is a key focus point right now as clients look to potentially shift their hedging and duration strategies. Since 2020, bank treasuries have increasingly used EUREX for clearing their ALM hedging strategies, with banks typically paying fixed at EUREX. Pension funds and asset managers have predominantly been receivers of EUREX swaps at the long end of the curve, and that has created an inverted curve in ULTRA's EUREX LCH basis.

Meridy Cleary: That's really interesting, and we'll definitely get into that EUREX LCH basis in a second. But maybe if we first turn to the in-scope products and firms, we know that EUR IRS, Polish zloty and EUR STIR are in-scope, right Roxanne?

Roxane Blanc: Yes, that's right. And we also know that the representativeness requirements across those classes of derivatives will vary depending on the size of the firm's derivatives portfolio, but also their structure. And in that sense, you won't be asked to start trading in an instrument that you don't already trade in. So first, firms need to run their own analysis to understand whether they need to comply and how they need to comply with regards to the particular sets of derivatives. When doing the calculations, that means that at max, the largest firms will need to clear around 1,200 trades at EUCCP per year. This, as we know, is easily achievable for the banks with large market-making desks. However, for the small or medium-sized market participants, the operational and reporting burden could play a key part in their strategies, and they could decide to shift fully away from LCH towards Eurex.

Meridy Cleary: Thanks. And of course, we're in this unique situation where market participants have to prepare to comply with the new rules without actually knowing the more descriptive Level 2 rules. So as of right now, ESMA's Level 1 rules have been finalized and have already entered into force. But we're waiting to hear back on ESMA's consultation, which closed at the end of January, on the more detailed Level 2 technical standards. So our clients listening can, of course, reach out at any point, as and when we get color on where we land post-consultation.

Roxane Blanc: Totally. As you mentioned, the final RTS could actually take a few months. The latest date that ESMA can submit the final RTS to the European Commission is June 24, but we could also hear from them earlier in practice. The main point is that market participants should not wait until this implementation date, as they will need to start to comply by June, which is just a few months away.

Meridy Cleary: Definitely. And as I mentioned, while we're waiting for this final RTS, the market has the draft RTS, which provides the direction of travel and enough for market participants to scope out their strategies. So Roxanne, the new reporting requirements have been a particular point of contention for the industry. Those in scope of the active account requirement will be subject to new reporting requirements regardless of whether they're subject to the operational, the representativeness requirement, or both. So this 85% exemption has been a key component. Could you talk us through what it means and how it might impact trading strategies?

Roxane Blanc: Sure. So it is expected that firms already clearing over 85% of their relevant derivatives at EUCCP shall be exempt from the operational conditions and the reporting requirements. This is significant as some market participants might decide to then fully move to EUCCP for their in-scope derivatives to actually get that exemption. In any case, the imbalance of flows that we have observed in the market should progressively fade as we get more participants involved.

Meridy Cleary: And of course, with these dynamics across CCPs, there's often the question as to the basis, which we talked about a little earlier. How do you see this evolving over time?

Roxane Blanc: Yeah. So this is another key question right now. Let's take the example of Eurex again. So today in EUR-IRS, you can easily trade either on LCH or on Eurex, but that might entail a difference in price. That difference or basis is actually a product that trades on its own and exists because of the imbalance of flows. Institutions that had already transitioned fully to Eurex will continue to only clear to Eurex. It was a big operational exercise for them to move a few years ago, and they are unlikely to go all the way back. Institutions that did a 50-50 approach and the rest of the markets will probably take a breather in sight of the relaxed approach that ESMA is taking. Net-net, we think that the Eurex LCH basis should trade in tighter ranges and drift towards zero as more institutions will have the ability to up the basis differences.

Meridy Cleary: Thank you. That's definitely a key topic right now. And in terms of market positioning, what are you seeing right now ahead of this regulatory change?

Roxane Blanc: Yeah, so we've observed already in the market quite a few activities related to that transition. Asset managers have been transitioning with CF30 plus Eurex cleared portfolios to LCH to take advantage of the basis inversion at the long end. SSA issuers are swapping their issuance on Eurex to take advantage of the 10-year Eurex LCH basis being positive in the 5-year to 10-year sector. European banks have been receiving swaps on Eurex on the NII theme last year after 10-year Eurex LCH which plus four basis fails. All of these are activities that should persist. On the other side, we've seen large hedge funds playing the normalization type trades along the forward curve.

Meridy Cleary: Interesting. And taking us to, I guess, another key market structure theme that's happening in parallel. And that is, of course, the Dutch pension reform where clients are looking to restructure their portfolios ahead of this major market structure shift from a defined benefit scheme towards a defined contribution system in the Netherlands. In-scope firms need to consider both EMIR 3 and Dutch pension reform simultaneously. So the cost impact for funds is mineral. So these are clearly topics that are kind of intertwined.

Roxane Blanc: It is true that some small pension funds have started to transition this year for their reform. But the timeline for this large industry transition is actually way longer than the one of EMIR. The recent proposal of amendment to put the potential reform through a vote of participants adds up to the uncertainty. In any case, additional costs implied by either change is something that will be scrutinized quite intensively by the funds themselves.

Meridy Cleary: Definitely. And of course, uncertainty is never good when it comes to market structure changes.

Roxane Blanc: Yes, totally. Today, obviously we focused more on the market impacts and potential expectations from a trading perspective. Most firms know whether they are in scope and to what extent. But we also know that June 24 is just a few months away. So currently, market participants are going through their own analysis and deciding on the way forward for them.

Meridy Cleary: Thank you so much, Roxane. We’ve covered a lot today, and there’s still so much that we could’ve discussed on this theme. Thank you so much for your time.

Roxane Blanc: Thanks, Meridy.

Meridy Cleary: To our clients, please don't hesitate to reach out to your J.P. Morgan sales representative to discuss our offerings in light of this regulatory change, including multi-branch account structures. And of course, stay tuned for more FICC market structure and liquidity strategy content here on J.P. Morgan's Making Sense channel. And please feel free to visit our JPMM page as well. Thank you and have a great day.

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