The Unfinished Work of the European Financial Supervisory Architecture: Navigating Brexit and a New EU Continental Proje

1. European Financial Supervisory Architecture: “unfinished work” with many Brexit headaches • and a fundamental greenfield • for a new EU Continental project • Professor Marco Lamandini • CFA roundtable – Amsterdam 18 April 2018

2. The EU supervisory architecture in permanent motion! • Evolutionary, butsubsidiarity-friendly, integrationis a necessity: Eitheryoukeeppedalling or youfall! Thisistrue for Europe, itisalsotrue for itsfinancialsupervisors! But with clearsector-specific, institution-specific and product-specificvariations! • Three key open points: • How to reconcile Single Market policies (levelplayingfieldgrounded in a Single Rule Book) with sufficientflexibility to accomodate fundamentaldifferences in market structure, macro-economic country-specificconditions, legacyproblems in the North/South Divide? • How to reconcilemicroprudentialpolicies with macroprudential and monetarypolicies (e.g. strenghtening capital requirements in a recession or whenmonetary policy ishighlyespansionary? dispersion of MREL securities and verypaternalisticinvestorprotection)? • Oneinstitutional model of supervisoryarchitecturefitsall? • Proportionality and adjustmentcapacity are key! • Even more so to respond to suddenchanges of the political set-up • (Brexit, US isolationism): an interesting green-field to test EU resilience

3. A bit of background:(I) Why a EU supervisory architecture, in the first place? • In the words of the European Commission • (Communication 20.9.2017, 3) • Financial integration lies at the heart of the Single Market and of the Economic and Monetary Union • It is easier to conduct financial activities cross-border if these activities are regulated and supervised consistently across all Member States (Single Market rationale) • Financial integration – for all its benefits – also expands the channels of contagion among Member States in the case of adverse shocks. Inadequate supervision in a Member State has spill over effects and becomes a source of risk elsewhere (financial stability rationale)

4. (II) The infancy: The Lamfalussy procedure and 3L3 Committees

5. (III) EU supervisory cooperation: from “small” to “extra large”! Scholten, Ottow, Institutional Design of Enforcement in the EU: The Case of Financial Markets, in Utrecht Law Review, Vol. 10, No. 5, December 2014, p. 85. Available at SSRN: http://ssrn.com/abstract=2552571

6. (IV) The current architecture of the ESFS: a snapshot

7. (V) ESAs not enough to address the vicious circle sovereigns/banks: the Banking Union • As the financial crisis evolved and turned into the Eurozone debt crisis, it became clear that, for those countries which shared the euro and were even more interdependent, a deeper integration of the banking system was needed as a precondition for Euro area financial support. That’s why, on the basis of the European Commission roadmap for the creation of the Banking Union, the EU-19 agreed to establish a Single Supervisory Mechanism and a Single Resolution Mechanism for banks. • Non Euro MS can also join. • The Third Pillar is still on its way! Deposit Guarantee Schemes (DGS) are still national and with limited fire power and risk dispersion.The Commission’s EDIS proposal for re-insurance and then co-insurance with the new DGS Directive is stuck political progress is slow.

9. (VI) Banking Union and CMU tell different stories! (a) Banking Union was momentous but to some extent easier • Banking is comprehensively regulated in the EU-28 by a mix of uniform – maximum harmonisation and minimum harmonisation rules (CRR, CRD IV, BRRD), grounded on Basel standards and their straightforward extension to the entire European banking industry (with little room for proportionality calibrations: but 2016 Risk Reduction Package is meant to better address it; more to come, though!). No surprise that retail commercial banking requires fully-fledged establishment in the EU and being subject to EU supervision: no “third country equivalence (TCE) recognition” but need to coordinate for GSIIs out of the Eurosystem. • Banking Union offers a good example of a “two speed” EU exercise of enhanced cooperation: in the EMU O&D are centrally exercised and supervision is centralised (is it a competitive advantage? Nordea move to Finland seems to say yes). T-122/15 L-Banken acknowledged that exclusive competence over all prudential tasks listed in Article 4 SSMR is granted to the ECB! NCAs are (legislatively) delegated some responsibilities on LSIs under ECB control…

10. No surprise SSM fared reasonably well so far but... with new challenges • There are new legal challenges: • Risk of discrimination: the enforcement of harmonized national laws by the ECB may occasionally lead to diverging outcomes because of still national preferences embedded in the national law the ECB is called to apply (e.g. fit and proper, in particular integrity requirements). It is new that the CJEU has to look also at national law! (see GCEU order 12 September 2017, T-247/16, Trasta Komercbanka), but now also ESMA may be called to enforce IFMD national implementing rules if applicable to ELTIFs ; • Complexity: an example are compound proceedings (vertically with NCAs and horizontally with SRB) and their judicial review (pending case CJEU C-219/17, Fininvest); another example is the division of competences with EBA (now question on EBA remit to plan EU supervisory priorities: does it threat ECB independence?) • “Creeping” “monopolisation”: do ECB supervisory competences implicitly encompass also prudential tasks under national law which are however considered within the frictional remit of ECB (ECB letters of end March 2017)? • And also SRB recently had its baptism of fire! Banco Popular pending cases show that “shared” competences between SRB and NRAs(FROB) are a multiplier of legal claims at both national and European level!

11. (b) CMU is more of a patchwork…but there are good reasons to move towards a CMSS • Heterogenity is the rule: It is difficult to adopt a unitary approach. • Different: • market players • products • markets and many “speeds” of their European regulation. • It is clear however that: • market infrastructures are key and they are European; • accounting and auditing still too national (thereby impairing effective comparability and delaying inward investment flows to Europe); • cross-border/interstate activities call per se for a single EU entry point for supervision (see now crowdinvestment EC March 2018 initiative!) • Five Presidents: Single CMU Supervisor as longer term objective! • In the words of the European Commission:“more seamless supervision promotes more integrated financial markets in the Capital Markets Union”. “Direct supervision at the EU level is in many cases the most effective way of delivering supervisory convergence, thereby removing barriers to cross-border activities and the scope for regulatory arbitrage” (EC, Communication, 20.9.2017, p. 9)

12. (VII) Brexit is just an elephant in the room: CCPs, CRAs, AIFs and more! • Two numbers are enough: • UK trade surpluses from financial services with EU in 2014: • 12 Billion revenues from market infrastructures (46% of overall EU sector revenues); 70% of clearing Eurodenominated derivatives trades in London; LCH clears over € 500 Billion a day with SwapClear (notional amount over € 87 Trillion) • 6 Billion revenues were from asset management (26% of overall EU sector revenues). • banking: 23% of overall EU sector revenues, and mostly thanks to US and foreign localisation in UK. • 5,500 City-based firms rely on 336,421 passports! • With an “hard”Brexit, LondonbasedCCPs can clear EU trades under the EMIR third country equivalence (3CE); No surpriseCCPsregulation and supervisionbecomes a thornyissue (today EC adopted 39 3CE under 14 different EU pieces of legislation): UK shallensure over the long run • Substantiveequivalence; • Compliance with equivalentrules; • Reciprocity (reciprocalrecognition of EU firms). • And this may be still not enough!

13. No surprise the first move was a new remit for ESMA on TC CCPs supervision, with a “silver bullet” for a possible relocation • Can EMU accepts that most of Euro-denominated transactions be cleared out of EU and of EMU? • ECB was unsuccessful in its first attempt: GCEU T-496/11. • But those were different times, well before Brexit (and current difficult negotiations). • Two new events: • ECB made its recommendation 22 June 2017 and Commission endorsed it with opinion 3 October 2017 to change Article 22 ECB Statute (to respond to GCEU concerns) and get the necessary firepower to impose relocation, if needed; • proposal of 13 June 2017 for a Regulation amending Regulation No 1095/2010 to establish the “CCP Executive Session” (One Head, 2 independent and members of the NCA and NCB where CCP is established) within ESMA tasked with supervision of Union and third countries CCPs post recognition. But ESMA can also propose to the Commission the the CCP should not be recognised, if the CCP is of “specifically substantial systemic significance”: in this case CCPs would be authorised to provide clearing services to EU clearing members and EU clients only if relocated and established in one Member State!

14. (VIII) This tells a story: ESAs extraterritorial reach (1) A focus on CCPs supervision:(a) the status quo • Under EMIR, EU CCPs are supervised by their home country competent authorities, with the assistance of colleges composed (Article 18) of • national supervisors; • ESMA; • relevant members of the ESCB; • other relevant authorities (like supervisors of the largest clearing members, of certain trading venues and of central securities depositories). • The colleges can include as many as 20 member authorities, under the chair and coordination of the home-country competent authority. Colleges “facilitate the exercise of the tasks” referred to authorisation, extension of activities and services, validation of models, stress testing and back testing of its risk control mechanisms, approval of interoperability arrangements. Three main concerns have been raised in respect of the current architecture for EU CCPs: • due to concentration of clearing services in a small number of Member States, supervisory decisions adopted mainly by the home-country supervisor (despite college’s assistance) have significant cross-border implications and may affect the EU financial system as a whole; • there are diverging supervisory practices (different authorisation conditions and different model validation processes) across the EU and they can create risks for arbitrage; • the role of central banks is not adequately reflected in the colleges. (nor in the ESAs)

15. In a nutshell: status quo means an “intervention-based” ESMA role. Clearly not enough! Third-country CCP are recognised by ESMA under Article 25 provided that cooperation agreements are in place with the home competent (Article 25(2) letter c) and 25(7). In particular Article 25(7) sets out that these arrangements shall specify at least: • the mechanism for the exchange of information with ESMA; • the mechanism for prompt notification to ESMA ; • the procedures for coordination of supervisory activities, including, where appropriate, on-site inspections. ESMA role on both EU and third-country CCPs currently reflects an “intervention based model”: it leaves day-to-day supervision at the level of the home supervisor and, at the same time, it allows ESMA to monitor and intervene when necessary in exceptional circumstances.

16. (b) The way ahead: (1) strengthened EU governance via the CCP Executive Session • Under the Commission proposal a CCP Executive Session is established within ESMA in the field of supervision of both Union and third-country CCPs (new Articles 44a, 44b and 44c). The Chair of such Executive Session will also chair any college (new Article 18 EMIR) and the members of the Executive Session shall have one vote each in the college (new Article 19 EMIR). ESMA may request information directly from an authorised or recognised CCP where information is not available (new Article 35 ESMA regulation). ECON Committee proposes amendments. • A) Supervision of EU CCPs shall be carried out by national competent authorities, but proper consent of ESMA and where appropriate of the competent Central Bank is required for several important supervisory decisions (new Article 21a as to the role of ESMA and new Article 21b as to the role of the competent Central Bank).

17. (2) Third-country CCPs: a two-tiered supervision and a leap forward towards ESMA and ECB extraterritorial supervision! • Supervision of third-country CCPs shall continue to rest on the European Commission’s determination of equivalence. However ESMA will be tasked with the monitoring of the regulatory and supervisory developments in third-countries CCPs regimes deemed equivalent (New Article 25(6b) EMIR). ESMA will also be tasked with the determination on whether a third-country CCP is systemically important or not, taking into account the criteria set out in new Article 25(2a). • For Tier2 CCPs additional requirements must be fulfilled to obtain recognition (so called “system of full application of EMIR via equivalence”).ESMA shall be responsible for supervision on an ongoing basis of the compliance with EMIR requirements • If, despite these additional requirements, Tier2 CCPs are considered posing a risk to the Union’s financial stability that cannot be sufficiently mitigated by a system of full application of EMIR via equivalence, ESMA, in agreement with the relevant EU central banks, has the power to recommend to the European Commission, that the CCP is not recognised and be established in one Member State.

18. Other, but different, examples of ESMA extraterritorial supervision: (I) Lessons from CRAs. • CRA’s certification is granted only if • the legal and supervisory framework of the third country is ‘equivalent’ to the EU CRAs’ regime according to the European Commission’s assessment (so far with Argentina, Australia, Brazil, Canada, Hong Kong, Japan, Mexico, Singapore, US); • appropriate cooperation arrangements are in place with the third country and its supervisor(s) and, most importantly, • the CRA does not have systemic importance for the stability or integrity of the financial markets in one or more Member States, and • the rating refers to a non-EU issuer or instrument. Reliance on equivalence and thus on third country substituted compliance via day-to-day supervision of the home (non EU) competent authority is warranted, for non-EU CRAs, only where non EU instruments are concerned and no risks of financial stability are at sight. Something that, mutatis mutandis, may closely resemble the situation of Tier1 CCPs in the envisaged EMIR reform. • CRA’s endorsement is made available for CRAs that are affiliated or work closely with EU registered CRAs, which endorse their credit ratings. The endorsing CRA is subject to direct day-to-day ESMA supervision (there is thus a double supervision) and assumes full and unconditional responsibility for ensuring that all the conditions for endorsement are met.

19. (II) Lessons from AIFMs • Another interesting example of de facto extraterritorial application of the EU supervisory regime via cooperation with third country supervisors is offered by AIFMD and this regime is quite significant for our purposes, because (i) severe disturbances in the AIF market may pose financial stability concerns for Europe and (ii) all investment funds originated from third countries, being by definition non-UCITs since they are not located and managed in the EU as required by Directive 2009/65/EC, qualify as AIFs. • EU-wide passport is offered to non-EEA AIFMs and AIFs, provided however that they accept becoming subject to substantially all the obligations of the AIFMD, including those relating to capital requirements, depositaries and remuneration, on a global basis (unless an exemption is granted, provided however that equivalent requirements apply in the third country) and an appropriate MoU is in place with the third country supervisor and the effective exercise by the relevant EU supervisory competences is not being prevented by the legal and supervisory regime of the third country.

20. (IX) New remits for ESMA on direct supervision! September 2017 Proposal • New remits • Prospectuses : Approval of certain categories of prospectuses by EU issuers Approval of all prospectuses drawn up under EU rules by third country issuers • Harmonised collective investment funds (EuVECA, EuSEF and ELTIF): Authorisation and supervision of funds which are regulated at the EU level • Central Counterparties (CCPs) Supervisory powers in relation to CCPs (Commission proposal of June 2017) Recognition and supervisory powers for third country CCPs (already existing; reinforced in Commission proposal of June) • Data reporting services providers Registration and supervision of data reporting service providers • Benchmarks Supervision of critical benchmarks Endorsement and supervision of third country benchmarks • A better governance! (Executive Boards) • A different funding (60 % via private fees) • And less on guidelines and recommendations! (art. 16)

21. And now some of the many open questions

22. Financial stability as the key engine for supervisory integration! • Armour, 2017 noted that, there has been a clear “shift in emphasis in financial regulation toward financial stability” and “preservation of financial stability necessitates international coordination”. This has given the EU “reason to rethink its traditional decentralised authorisation model for third country firms” because “decentralised decision-making makes it harder to control systemic risk”. ESMA is granted a pivotal role in this, and this is so because it is the only EU-28 financial supervisory agency with experience of direct supervision. The paradox is that ESMA has little financial stability standing compared to other authorities. • In the proposed reform of CCPs supervision a complementary role is also given to the central banks of issue. This is in turn consistent with the emphasis recently given to financial stability in the fulfilment of the central bank mandate, in particular for the ECB, for which the preservation of financial stability can be considered a secondary and complementary mandate alongside the price stability mandate, based in Article 127(1) and (5) of the TFEU. Moreover the smooth functioning of the payment system is also at stake, when financial stability concerns arise.

23. But still an unfinished work:micro and macro policies can be at war and architecture is becoming confusing A microprudential view still prevailing: Even if the financial system’s interconnectedness is well-established, as well as the need for coordinated action that tackles the problem at the level of the “network”, the resilience of micro-prudential rather than macro-prudential logic of supervision, based on allegedly only national fiscal burdens, is surprising. striking that CCPs supervision assigns also prudential remits to ESMA, albeit to be exercised in agreement with the ECB and the other central banks of issue, whilst no role whatsoever is foreseen for the SRB for Tier 2 CCPs with the proposal on CCPs recovery and resolution. Functional allocation of tasks and powers may get confusing (no twin peak model yet, due also to reliance on ECB for SSM; complex interplay between EBA and ECB). Could this be an indication that, in due course, due to the gradually increasing remits of direct supervision conferred upon ESMA, path dependency may take Europe to choose a consolidated supervisor model rather than a twin-peak model? How does it sit with the increasing centrality of the ECB, via the SSM, as dominant banking prudential supervisor in Europe? the relocation of Nordea into the eurozone and Brexit are signalling that SSM will play a central role.Yet, this rationale would have perhaps justified a CCPs supervisory reforms more closely mirroring the SSM/SRM.

24. Is Article 114 TFEU legal basis strong enough to support conferral to EU agencies of wider direct supervisory powers? • ESMA shortselling (C-270/12) case is key. But different opinions on its reading! (e.g. Council Legal Service opinion on ESAs reform). Does it also support imposition of supervisory fees or should Artile 311 TFEU apply? (see EC non paper and Council legal service opinion). • Are Meroni (ECJ 9/5&) concerns dispelled forever, or should we be concerned that discretion under the proposed ESAs Regulation is too wide and not sufficiently subject to ex post endorsement of other EU institutions (as it is the case for SRB)? An opinion of the Council Legal Service is announced this. • Will the flows of more than 100 pending cases before the GCEU on the Banco Popular affaire offer the opportunity to the court to say a final word on this? • It is crucial that all these legal doubts be rapidly dispelled because technological advances make it urgent to have duly funded, very operational EU tech-authorities as fully fledged regulators, also with some direct supervisory powers on all EU-wide or cross-border matters!

25. Conflicting forces are at work in the ESAs reform: risk of inconsistencies? • Direct supervision calls for a more centralised governance with a EU-centered Executive Board whereas coexistent single rule book tasks would be still aligned with current governance (more subsidiarity oriented) (D’Ambrosio, 2018). • Direct supervision is strengthened but harmonizing powers under Article 16 are weakened and Article 9(5) has not been made a self-standing empowering rule on temporary intervention and merit review (D’Ambrosio, 2018). • ESAs funding has been changed imposing supervisory fees to the industry. It is however unlikely that funding will be enough to cope with the very IT intensive and very costly rearrangement of the supervisory role compelled by technological advance and FinTech! • EBA/ECB relation may become a breeding ground of complexities: ECB soft law may clash with EBA role and EBA EU supervisory planning may clash with ECB independence? Ins’t it illusory to divide regulatory and oversight functions for a financial regulator?

26. And to conclude a few very specific questions: (1) Is the ESMA Executive Session for CCPs a workable governance tool? • If, however, ESMA governance is going to be thoroughly reshaped within the context of the ESAs reform as envisaged in the proposal for an amending regulation put forward by the European Commission in September 2017, precisely to ensure a predominance of the “EU-wide” interest, a “two-headed” organizational structure for ESMA may become unnecessary and a breeding ground for complexities and conflicts. • Merging or at least bridging, on this point, the two reforms seems possible, by ensuring that at least three of the 6 members of the Executive Board of ESMA have the skills and experiences currently required for the Head and Directors of the CCP Executive Session and shall be assigned with the corresponding responsibility. Providing that they should sit in the CCP Executive Session being at the same time fully fledged members of the Executive Board would be a simple (and, in principle, easy to get) adjustment to the current proposals, if further major amendments to the structure and role of the Executive Session were considered premature or difficult to achieve in the current legislative process.

27. (2) Is the middle-ground of an ESMA Executive Session better than proportionate oversight centralisation? • There is though a more fundamental question. Is reliance on colleges of supervisors for EU CCPs, mediated by the complex role and structure of the ESMA Executive Session (with the Head of the CCP Executive Session chairing the college and the permanent members having voting right, with the exception of the member appointed by the European Commission), preferable to a straightforward oversight centralisation under the responsibility of ESMA, with the national competent authority participating to relevant decisions affecting CCP established in that Member State (like in the SRB setting for resolution decision)? • ESMA’s peer reviews have revealed substantial differences in national supervision and within the CCPs’ colleges, also “in the methods applied by the CCPs to determine the initial margins and the default fund contributions”.

28. (3) Is the tiered approach to third-country CCPs worth some additional fine-tuning? • Tier 2 CCPs should in principle be subject to joint supervision by ESMA (and with a significant role for the central bank of issue) and their home country supervisor, under the necessary cooperation arrangements. This is a new, interesting, example of extraterritoriality in global financial regulation: and one which nicely exemplifies the existing “trade-off between financial stability and open markets”, the perils which lie beneath unilateral decisions of equivalence, when “each state decides unilaterally whether another country’s regulation and supervision is ‘equivalent’ or ‘substituted compliant’ with its own” and the sensible opportunity of the academic view claiming that “from a macroeconomic viewpoint, it would be better if the comparison of different regimes were put in the hands of a neutral body, for instance a panel of regulators chosen from different countries”. • Only future will tell if this new system will fare better than the existing one (EMIR rules on equivalence), which, in the words of the European Commission, “demonstrated certain shortcomings as regards ongoing supervision in third countries, meaning that EU authorities may not become aware of new or growing risks to the EU financial system”. Much will depend on how ESMA will exercise the extra-territorial supervisory prerogatives.

29. (4) Should the majority of euro-denominated trades be cleared in the EU? • This also introduces to the most controversial part of the proposal. Tier2 third-country CCPs that are of “specifically substantial systemic significance” for the EU could become a third class, for which ESMA, in agreement with the relevant EU central banks, has the power to recommend to the Commission that they should not be recognised (in this way imposing relocation within the EU, to be able to provide clearing services to EU clearing members and EU clients). • Relocation would come, however, with its (great) costs: the biggest threat comes from the loss of systemic efficiency and liquidity which would derive from a fragmentation of central counterparty’s activities among multiple CCPs within the European Union.

30. (5) Does the EU general principles of non-discrimination and free movement of capital apply for third-countries CCPs, and if yes, how? • This takes us to the last question. To what extent free movement of capital, with its erga omnes effects, and the general principle of non-discrimination under Article 18 TFEU, already invoked by the United Kingdom in case T-496/11, could stand in the way of such a forced re-location, considering that extraterritorial day-to-day ESMA joint supervision (fed by ECB requirements) may be feasible, more aligned with comparable international practice and less disruptive?

31. ESAs reform is a fundamental greenfield for the new Continental Europe! N. Moloney, 2017: “The role of the ESAs should not be overlooked, given their technocratic capacity and growing influence on EU financial governance; in particular ESMA can be identified as an important institutional actor in relation to the Brexit negotiations, not least given its potential as a location for EU level supervision and/or coordination relating to UK-located capital market business and its experience with equivalence-related decision making and supervisory coordination”