Considered in Grand Committee
That the Grand Committee do consider the Over the Counter Derivatives, Central Counterparties and Trade Repositories (Amendment, etc., and Transitional Provision) (EU Exit) Regulations 2018.
My Lords, as this instrument has been grouped, I will speak also to the Financial Markets and Insolvency Amendment and Transitional Provision (EU Exit) Regulations 2019.
As with the instruments we have just debated, these two instruments are also part of the same legislative programme to ensure that if the UK leaves the EU without a deal or an implementation period there continues to be a functioning legislative and regulatory regime for financial services in the UK.
Turning to the substance of the over-the-counter derivatives, central counterparties and trade repositories SI, many noble Lords will be familiar with the European market infrastructure regulation known as EMIR, which the EU implemented in 2012. It is Europe’s implementation of the G20 Pittsburgh commitment in 2009 to regulate over-the-counter derivative markets in the aftermath of the financial crisis, reduce risk and increase transparency in derivative markets. It should be noted that EMIR, and the financial markets and insolvency SI which we will come on to in a moment, concern activities that mainly take place on financial markets. EMIR imposes requirements on firms that enter into any form of derivative contract and establish common organisational, conduct-of-business and prudential standards for trade repositories and central counterparties. Central counterparties, for example, stand between counterparties in financial contracts, becoming the buyer to every seller and the seller to every buyer. They guarantee the terms of a trade, even if one party defaults on the agreement, thereby reducing counterparty risk.
This SI addresses deficiencies within EMIR and related UK legislation to ensure that after the UK has left the EU an effective legal supervisory and regulatory framework for over-the-counter derivatives, central counterparties and trade repositories remains. This instrument is the last of three key SIs that fix deficiencies in EMIR, and it follows two SIs which have already been debated in your Lordships’ House and which have subsequently been made: the central counterparties SI and the trade repositories SI.
Firstly, the SI continues key requirements of EMIR that include the clearing obligation, which requires firms to clear certain types of derivative contracts at a CCP, the reporting obligation, which requires firms and CCPs to report derivative trades to a registered or recognised trade repository, and margin requirements, which compel firms to put forward money to cover the costs associated with trades. In order to have a framework in place to facilitate these requirements the relevant functions are transferred from the European Commission to the Treasury, and from the European Securities and Markets Authority—ESMA—to the UK regulators, namely the Financial Conduct Authority or FCA, the Prudential Regulatory Authority, known as the PRA, and the Bank of England.
Secondly, the power of granting equivalence decisions for non-UK trade repositories is transferred from the European Commission to the Treasury and functions for recognising non-UK trade repositories are transferred from ESMA to the FCA. The SI also transfers powers from the Commission to the Treasury with regard to equivalence decisions on over-the-counter derivative requirements and whether non-UK markets are recognised for the purpose of trading exchange-traded derivatives.
Thirdly, a temporary intragroup exemption regime provides continuity by ensuring that exemptions from EMIR requirements for intragroup transactions will continue after exit day. The regime will last three years from exit day to allow time for consideration of an equivalence decision by the Treasury and for the FCA to determine a permanent exemption. This period can be extended by the Treasury if necessary. Under the MiFID II legislation, there is an exemption from clearing and margining for certain energy derivative contracts, and this exemption is maintained by this instrument. Finally, EU processes which will become redundant are removed and replaced with equivalent UK processes.
I turn now to the financial markets and insolvency SI. This instrument, broadly speaking, concerns insolvency-related protections that are provided to systems and central banks under the EU settlement finality directive, or SFD. Systems are financial market infrastructure, such as central counterparties, central security depositories and payment systems, which provide essential services and functions relied upon by the financial services sector.
Currently, if an EEA-based system is designated under the SFD and receives funds or securities from a system user—for example, a UK bank—those funds or securities cannot be clawed back in the event of the UK bank being subject to insolvency proceedings. Importantly, this framework also benefits system users, who could receive services on less favourable terms, or not at all, if the EEA system were not protected from UK insolvency law. In certain cases, membership of a system is contingent on these protections. Designation is therefore important as it facilitates the smooth functioning of, and confidence in, financial markets.
In order to become a designated system, a system must be approved by its designating authority—the Bank of England, in the case of the UK. The Bank then informs ESMA, which places it on the EU register of designated systems. The SFD provides similar protections to central bank functions across the EEA. Collateral received by an EEA central bank in accordance with its functions, such as emergency lending, cannot be clawed back if the relevant counterparty to the central bank is subject to insolvency proceedings.
The relevant EU laws—the SFD and the financial collateral arrangements directive—are implemented in the UK via the Financial Markets and Insolvency (Settlement Finality) Regulations 1999, the Companies Act 1989, the Financial Collateral Arrangements (No. 2) Regulations 2003 and the Banking Act 2009. Should the UK leave the EU without a deal or an implementation period, there will be no framework for the UK to recognise systems designated in EU member states, which in turn may risk continuity of services from those designated systems for UK firms.
This SI therefore establishes two main measures to mitigate these risks and ensure that settlement finality protections continue to operate effectively following the UK’s withdrawal. First, this SI establishes a UK framework for designating any non-UK system, while maintaining existing designations for systems that were designated by the Bank of England before exit day. To do this, the Bank of England’s powers to designate, and charge fees to, UK systems will be expanded to non-EEA systems, such that they can be designated under UK law. Moreover, the Bank will be able to grant protections to non-UK central banks, including EEA central banks, which already receive protections under the SFD. This will help maintain the effect of the current framework, providing continuity to UK firms accessing systems and central banks, while assisting UK firms in accessing the global market.
Secondly, the SI establishes a temporary designation regime. This provides temporary designation for a period of three years to existing designated EEA systems that intend to be designated under the UK’s framework. The purpose of temporary designation is to allow time for designation applications to be processed by the Bank of England while ensuring continuity of access for UK firms to relevant EEA systems immediately after exit day. The SI also gives the Treasury the power to extend this regime should more time be required to consider these applications.
The Treasury has been working very closely with the regulators in the drafting of the instruments. It has also engaged the financial services industry on these SIs and will continue to do so going forward. The Treasury published these instruments in draft alongside Explanatory Notes to maximise transparency to Parliament, industry and the public. That took place on 22 October and 31 October 2018 respectively for the Over the Counter Derivatives, Central Counterparties and Trade Repositories (Amendment, etc., and Transitional Provision) (EU Exit) Regulations 2018 and the Financial Markets and Insolvency (Amendment and Transitional Provision) (EU Exit) Regulations 2019. Furthermore, the Treasury published the impact assessment that accompanies these SIs, providing further transparency regarding the reasons behind, and foreseen impacts of, these proposals.
The Government believe that the proposed legislation is necessary to ensure the smooth functioning of financial markets in the UK if the UK leaves the EU without a deal or an implementation period. I hope that noble Lords will join me in supporting the regulations. I beg to move.
My Lords, as the Minister noted, the first SI—dealing with OTC derivatives, CCPs and trade repositories—was published in draft on 22 October last year. The second, dealing with financial markets and insolvency, was published in draft on 31 October last year. The impact assessments for these SIs are contained in a consolidated batch of nine HMT impact assessments, which themselves rely occasionally on references to IAs for other SIs. That batch was published on 29 January, three months after the publication of the drafts and two working days before we were scheduled to debate them. Even one working day beforehand, last Friday morning, the IAs were not available in the Printed Paper Office. Can the Minister explain the very late appearance of the SIs and why the PPO did not have copies by Friday? Can he reconcile this late publication of IAs with giving Parliament proper time for scrutiny? Can he assure the Committee that future Treasury IAs will be published in good time and lodged with the PPO?
The consolidated IAs contain a headline assessment of cost and benefits. As to costs, there are three headings: “Total Transition”, “Average Annual” and “Total Cost”. In each case, the IA estimates the costs as “Unknown: likely significant”. This is unsatisfactory and raises the question of whether HMT understands the role that IAs play in parliamentary scrutiny. It is of no help that the consolidated IA reckons the benefits to be “significant” but declines to attempt to quantify them. In the remaining 52 pages of the impact assessment there is no real detailed examination or quantification of likely costs and benefits, apart from a reading time-based estimate and a passing reference to the trade repositories SI where costs are estimated, apparently, at £500,000 per TR. I say “apparently” because there is a typo in the cost reference for these TRs, so it is not clear whether the figure is meant to be £50,000 or £500,000. Perhaps the Minister can clear that up. I think that it would help the Committee in its scrutiny of future Treasury SIs if consolidation was avoided and we returned to individual impact assessments in proper form for each SI.
Turning to each SI, I found it quite hard in parts to follow the EM for the OTC derivatives, CCPs and TRs SI. I would be grateful for some clarification from the Minister. In paragraph 6.1, the EM notes that the SI revokes two pieces of delegated legislation. Will the Minister expand on what these are and why they are being revoked? The EM does not say why—or if it does, I could not find it. In paragraph 7.7, the EM explains that:
“As a general principle, the UK would need to default to treating EU Member States largely as it does other third countries, although there are cases where a different approach would be needed including to provide for a smooth transition to the new circumstances”.
The EM does not explain what these cases may be or what the different approach might be. Will the Minister tell the Committee what these cases are, or may be, and what different approaches will be needed, and why?
Paragraph 7.12 of the EM states:
“Where the Commission has taken equivalence decisions for third countries before exit day, these will be incorporated into UK law and will continue to apply to the UK’s regulatory and supervisory relationship with those third countries—with the exception of those taken under Article 25 EMIR as set out in the CCP Regulations”.
Will the Minister explain what these exceptions are and why they exist?
In paragraph 7.16, the EM notes that the SI introduces a power that allows the FCA to suspend the reporting obligation for up to one year, with the agreement of HM Treasury, where there is no registered UK TR available. Surely the Treasury must know how likely this is and who it will affect. Again, the EM and the impact assessment do not help—or at least did not help me. Will the Minister say how likely this suspension is, who it will affect and what its consequences and impact might be?
I turn briefly to the second instrument, the financial markets and insolvency regulations, which is, by comparison, a model of clarity and straightforwardness. My only question relates to paragraph 1.76 of the impact assessment, which explains that the relevant EEA systems will be required to notify the Bank of England, before exit day, to enter the regime. What happens if they do not? What risks does this generate, and what procedures are in place to mitigate them?
I realise that I have asked quite a few quite detailed questions, and if the Minister prefers to respond in writing I would be happy, as long as we have the answers before the SIs reach the Chamber. I emphasise that I feel strongly that the consolidation of IAs makes proper parliamentary scrutiny significantly more difficult, and the very late production of IAs, as in this case, really does not help.
My Lords, there is much that I would support in the intervention by the noble Lord, Lord Sharkey. I particularly like the way he sneaked in the fact that he got to page 41 of the IA.
The first instrument is on an area that I knew little about before I read it. With that limitation, it seems generally to make sense. It is clear about the transfer of functions, who will be responsible for equivalence decisions and information exchange—data comes over with a discretionary relationship. It is clear that the object of the exercise—at least this is how I read the Explanatory Memorandum—is to retain the discipline of EMIR. In view of its importance, I was surprised that a UK name for EMIR was not created, as was done in a previous SI, so that we would all know what we were talking about, given that the E in EMIR stands for European.
Going a little way into the detail, as the noble Lord pointed out, paragraph 7.16 allows a reporting obligation to be suspended for one year. From what I understand of the overall regime that this is part of, its very essence is open reporting of transactions. That is what the G20 came up with to create this regime. Will the Minister give us some feel for what risks are being taken by Part 2 of the instrument, which creates an opportunity for reporting to be suspended for up to one year? It also has what seems a fairly reasonable exemption for intragroup activity. It is a classic three years, plus however often the Treasury wants to extend it. It also has an exemption for energy derivative contracts up to 3 January 2021, but I could not see where that date came from; perhaps it is something to do with an international agreement.
In paragraph 7.22, the instrument introduces or changes some criminal offences. I looked back at the document that enables this, the European Union (Withdrawal) Act 2018. I assume this is being done under Section 8, under which most of this is being done. Section 8(7) states,
“regulations under subsection (1) may not … create a relevant criminal offence”.
I would therefore like some assurance from the Minister that the changes outlined in paragraph 7.22 are legally correct.
The essence of the financial markets and insolvency regulations is to prevent clawback in insolvency situations, which is presently automatic for non-UK EEA members. This will fall away on exit day, but this SI gives the Bank of England power to designate, and there is a temporary designation regime with the traditional format of three years and 12 months. However, does this create an asymmetric situation? Do UK firms participating in EEA countries receive the same protection?
This is quite an important question. At the moment, LCH is the dominant clearing house globally and it is certainly the dominant player for any euro-denominated transactions. There is a shift under way to take some of this activity to Paris. The real question for a lot of the UK players is whether they have to relocate part of their operation to Paris to be able to play in both parts of what will become a much more fragmented European clearing system. That matters a lot for terms of compression and deciding what levels of margin companies have to keep. The reciprocal play matters. Today, the Bank of England and ESMA signed an MoU on how they will regulate these central counterparties. I do not know whether, or to what extent, that is the context. Am I being clear? No, I am being confusing.
No, that is very good. It might turn my casual question into quite a substantial one.
I notice that all the Treasury SIs that the Committee has discussed say that there will be no consolidation and no guidance. I do not know how we can carry on like this. I have found it absolutely impossible to understand the overall scene that these SIs relate to. The scrutiny that one is able to give is therefore entirely dependent on the Explanatory Memorandums. As a generality, these assume quite significant previous knowledge and it is an uphill battle to get a feel for these SIs and to give them the appropriate scrutiny.
My Lords, I am grateful to all noble Lords who have taken part. I detected no objection to the basic premises on which these SIs are based. I will sweep up some of the points raised in earlier debates that are also relevant to this one.
The noble Lord, Lord Tunnicliffe, asked about the FCA’s resources to cope with the new responsibilities being imposed on it. We are confident that the FCA is making adequate preparation and is effectively resourced ahead of March this year. In its 2018-19 business plan, a significant proportion of its resources are already focused on the forthcoming exit, including arrangements to implement any necessary changes. It has increased its staff numbers in response to increases in the scope of its regulatory activity, including EU withdrawal. It will publish its 2019-20 plan this spring, setting out its planned work for the coming year. As I said in response to an earlier SI, the chief executive of the FCA, Andrew Bailey, has said he expects to hold FCA fees steady for a year or two, assuming there is an implementation period. If there is not, it can increase its fees should it need to do so in the event of no deal.
The noble Lord, Lord Sharkey, asked about the impact assessment being published late. This issue was raised in another place and was dealt with by my ministerial colleague John Glen. We do recognise the importance of making impact assessments available for parliamentary scrutiny. We find ourselves in a unique situation. While we have tried to ensure that these impact assessments are published before debates, this has not always been possible. We acknowledge that some firms will incur costs as a result of these SIs but, as the noble Baroness, Lady Kramer, said in an earlier debate, the situation for these businesses would be much worse in the absence of this legislation. As a whole, these SIs will reduce costs to business in a no-deal scenario as without them the legislation would be defective. In response to the points raised by both noble Lords and the noble Baroness, we have agreed to undertake further analysis of these SIs in the event that we leave the EU without a deal and they come into effect.
The noble Lord, Lord Sharkey, asked whether we could have independent assessments for SIs. I understand that, but there are some complex interdependencies between some of the SIs. Also, the work that the regulators are undertaking cannot always be neatly pigeonholed between the SIs. Given that, it has not been possible to fully quantify the impact of the individual SIs at this stage. However, this is something that Miles Celic, the chief executive of TheCityUK, noted in a letter to the RPC in November. As I said a moment ago, we are committed to undertaking further analysis of the impact of these instruments at an appropriate point, should they come into effect, either in the event of leaving without a deal—
We hear that explanation and I have great sympathy for the civil servants involved with this task. However, will the Minister at least have the grace to admit that it was entirely in the Government’s hands to decide when to start this process? If they had started it earlier we would not be in this mess now. We have had impact assessment after impact assessment delivered after we have approved the instrument. That is not satisfactory and I doubt whether the Treasury will be able to catch up.
I plead guilty as charged. As I said a moment ago, we recognise the importance of parliamentary scrutiny. We will try to do better and make sure that the relevant impact assessments are available in time.
I asked about the absence of the impact assessments from the Printed Paper Office. That is the route by which most of our colleagues get the information. They were transmitted electronically to some noble Lords on 29 January, but they were not available in printed form until this morning. That seems a very odd lapse.
Again, I take that seriously. Would the noble Lord allow me to make some inquiries within the machinery of government in this House to find out what exactly went wrong there? I understand that they were delivered to the Printed Paper Office on Friday.
Having gone to the Printed Paper Office myself well into the afternoon, I know that if the Printed Paper Office had received them, it was not aware it had, so there is something there that needs investigation.
We need a post-mortem on this, which I will authorise.
In response to the question put by the noble Lord, Lord Sharkey, regarding the numbers on the impact assessment, and how they relate to trade repositories, I say that there are eight trade repositories operating in the EEA that are in scope of familiarisation costs. The impact assessment confirmed that we anticipate that the IT costs for those TRs will be approximately £10,000 to £15,000 per TR—although this cost is also dependent on the size of the TR—and, for firms that will need to update their systems, £5,000 per firm. Costs to the FCA associated with supervising the trade repositories, as well as new IT systems to connect to trade repositories, would be approximately £500,000 per trade repository, although this cost is also dependent on their size. The impact assessment also acknowledged that there may be other costs associated with trade repositories connecting to the Bank of England.
I think it was the noble Lord, Lord Tunnicliffe, and it may have also been the noble Lord, Lord Sharkey, who asked about the FCA’s power to suspend the need to report if there were no trade repositories. That is most unlikely. There are a number of trade repositories in the UK and there are arrangements in the legislation to passport them so they carry on. There are also arrangements for relatively speedily authorising any new TRs. It was slightly odd that a city such as the City of London did not have any TRs, so we think it most unlikely that the FCA will utilise its power to suspend reporting obligations against that background.
In the earlier debate, the noble Baroness, Lady Kramer, asked me whether the EU was considering reciprocity to UK funds in a no-deal scenario. The EU has not done the same for UK funds passporting into the EU, but many UK asset management firms operate EU fund ranges, and they have welcomed the creation of the temporary marketing permission regime, which enables them to market them into the UK.
I was asked what happens to an EEA system that does not notify the Bank of England of entering the TDR. Such a system will not enter the temporary designation regime and it will therefore not have recognition for UK insolvency law purposes. A notification is not an onerous requirement; the Bank of England provided details of this last autumn. The noble Lord, Lord Tunnicliffe, pointed out that under Section 8 we cannot create any new criminal offences, or, I think, create new taxes or new public authorities, and I am confident that nothing in the SIs goes against that restraint.
The appropriate paragraph does say that you are substituting one set of criminal offences with another. I can find it and read it if you like; it is a real question. I think the answer is in the word “relevant”.
The noble Lord asked a good question: is the creation of a criminal offence consistent with the withdrawal Act? Section 8 outlaws the creation of a relevant criminal offence. This is defined in Section 20 of the Act as an offence with a possible prison term of more than two years. The criminal offence in this SI is not caught by that definition, so it is permitted.
Following an intervention from the noble Baroness, Lady Kramer, I was asked about unilaterally recognising EEA systems as central banks with no EU-wide reciprocal action. Extending settlement finality protections unilaterally reduces the risk that UK firms will be refused access to EEA financial market infrastructures, known as systems, and central banks once the UK leaves the EU. It also reduces the legal uncertainty and settlement risk these systems and central banks would face regarding UK law without such protections, so it ensures that the UK remains an attractive place to do business in a global context and supports broader financial stability.
I am conscious that I might not have answered all the penetrating questions from the noble Lord, Lord Sharkey, or some others that have been raised. If I have not, I will write to noble Lords, I hope with an authoritative reply.