When in 2009 the G20 essentially deemed that 'everything had to be regulated', clearing swiftly became a bone of contention between the UK and the EU. Almost a decade later, Brexit looks likely to revive the old arguments, writes the former chair of the European Parliament's Economic and Monetary Affairs Committee.

Sharon Bowles

During the financial crisis, the much-lauded London G20 meeting in 2009 – chaired by then UK prime minister Gordon Brown – committed to strengthening national and global financial supervision and created the Financial Stability Board. Put colloquially, everything had to be regulated.

The next five years saw a surge of regulation that kept me occupied, as chair of the European Parliament’s Economic and Monetary Affairs Committee, not least actively chairing all the so-called 'trialogue' negotiations between the European Parliament, the European Council and the European Commission. Clearing rapidly became a subject of attention and dispute between the UK and the EU, and the eurozone in particular. The 2011 'location policy' of the European Central Bank (ECB) required clearing houses with daily exposures of more than €5bn in one of the main euro-denominated categories of derivative to be located in the eurozone.

Eventually this was taken to the European Court of Justice (ECJ) by the UK, with support from Sweden, but not before running battles on the issue during the negotiation of the European Market Infrastructure Regulation (EMIR). A return to the issue in the EMIR review was always likely; Brexit adds more heat.

Tendency to centralise

There has always been a tendency for some in the eurozone to centralise operations. With the challenging project of a fledgling-yet-large currency union it is understandable, but protectionism never seemed the right answer in the EU or the international context; it looked regressive. Nevertheless, the touch-paper had been lit by the G20 'regulate everything' decision and immediately that raised the question of where it should be supervised. It should be remembered that at this time the European Supervisory Authorities were being created. 

Some eurozone politicians and central bankers set their sights on eurozone location and supervision of central counterparties (CCPs). It sat ill with the EU single market, and still does, and although the threat can also come from an EU location policy effected through refusal of equivalence, Brexit has brought it to the centre stage again. It adds an argument about the ECJ not being the ultimate referee, although the court’s role has never been tested in issues of a financial crisis.

There are various strands to the clearing conundrum: commercial efficiencies and liquidity that are enjoyed by customers of London-headquartered LCH that will be lost if clearing is fragmented; supervision and systemic risk; and politics. The strands intertwine.

A lot has been written about commercial efficiency, so I will focus less on that. The benefits of netting over global currencies are substantial and the point is well made that fragmentation would lead to permanent cost increases, never mind the cost and risk of moving to a fragmented system. It is not a matter of swallowing changes and then getting back to where you were. The new normal would be permanently more expensive and the consumer would pay, as ultimately there is nobody else. There would also be a risk spike if lots of contracts have to be rewritten and moved, which brings us to the second strand: supervision and systemic risk.

Supervision and risk

Since the financial crisis, massive international effort and coordination has gone into getting almost everything centrally cleared, and then into the supervision, systemic importance, and potential resolution and recovery of CCPs. It was the crisis response that increased the systemic relevance of CCPs; an international issue that, by virtue of CCPs’ clearing members, touches all major banks, financial institutions and their clients.

In a systemic situation there may be a requirement for liquidity support from supervising central banks. During the financial crisis, central banks acted internationally, opening up substantial swap lines. One of the first needed was for the ECB to have a sterling facility with the Bank of England (BoE) due to the sterling exposure of Irish banks, but the US, Japan, Canada and Switzerland all have agreements with the ECB and a swap line with China was set up in 2013.

The provision of liquidity by a supervising central bank gives rise to several points. First, it is the supervising central bank, essentially the country, which carries the liability. It is not clear how this duty is discharged at the EU level. Is there to be a supervising member state, EU or a eurozone supervisor? Euro liquidity comes from the ECB and it also claims a role in financial stability, but at present it is barred from being a CCP supervisor by the Single Supervisory Mechanism (banking union) legislation that specifically excluded these entities from the ECB’s supervisory powers.

Unanimity among all EU member states is required to amend that regulation, and one of the reasons the restriction is there is for separation of monetary policy and banking supervision. Furthermore, within the Banking Union and Single Resolution Mechanism, the mutualisation of losses in resolution of banks is a very small and slowly moving matter. So there is a question about whether the liability of CCP resolution could be readily absorbed at the EU/eurozone level, and how soon.

The liquidity question

That gives rise to a second question: where is the liquidity going? Some may be needed by the CCP, but the destabilisation of a systemic CCP will occur due to substantial defaults among its main clearing members – the international systemic banks. Liquidity lines will be to the banks, which gives rise to the issue of who is supervising them. The answer to that is internationally spread – one of the reasons for supervisory colleges and crisis management groups.

The UK supervision of CCPs does not suffer from resolution ambiguity and the UK knows well the cost of standing behind every bank, branch and subsidiary and preserving its long-standing international reputation. Some might think the ECB gets a good deal from having a working relationship with the BoE without supervisory liability, other than its role supervising eurozone banks and thus stability of some clearing members, but there is a lot of politics about. By comparison, lessons could be learned from the co-operative 'common cause' supervision that has existed for 20 years for CLS Bank and foreign exchange, including legal principles on finality of payment.

A divisive policy issue is whether it is correct for supervisors to interfere with margin requirements for reasons other than inadequate risk management. The issue here is that for sovereign-related instruments, margin changes can have the same effect as sovereign rating changes. Where there is agreement is information exchange, and making sure the lines of communication are open, known and understood.

Where there is a difference of opinion is whether pressure should be brought to bear to make or prevent change, or even use it as a political tool. The market-orientated Anglo-Saxon world sees this as a no-no, others see it as the type of operational manoeuvre that central banks should be allowed that differ from rules for the open markets. Some claim the ECB should be able to stop margin calls that bring about a need for it to provide liquidity lines to its banks.

Every jurisdiction could say that, but it does not fit the realities of CCP risk margins that require commercial justification – with political concern of competitive pressure far too low rather than too high – nor the systemic reality that international clearing requires genuine international supervisory co-operation.

Effect of Brexit

These policy differences lead straight to policy-makers, politics and the final strand. Alongside the different policy perspectives and Eurocentric tendencies already mentioned, there is the Brexit effect. It is human nature for the remaining EU countries to try and divide the spoils, but things do not always turn out as expected. Some of the supervisory arguments raise international eyebrows. Being precious over location policy, in a way that other countries are not, does not sit well with the euro as an international currency.

Indeed, at a time when China is taking steps to internationalise the renminbi, it is an unfortunate contrast to see the EU head in the opposite direction: effectively to de-internationalise the euro and euro business. That is what location policy does, especially in combination with attempts to create an introspective capital markets union. History shows that markets do not like de-internationalisation and do not like being straitjacketed; the eurodollar should remind us of that every day.

The European Parliament has always had many voices favouring location policy and the EU may collectively rush to forbid its commercial companies from using London. The UK has a more let-live-and-adjust style of legislation rooted in common law, in contrast to the plan and control that characterises EU legislation. This difference is visible in the debate over clearing and Brexit. Perhaps it is one of the original reasons for London’s international success.

Fragmentation of clearing could happen because it is possible for the EU to engineer the legislation, setting aside the international co-operation that grew out of the financial crisis. I doubt that it will do anyone any good and I can imagine only too well the EU negotiations over mutualising the liabilities.

Baroness Bowles of Berkhamsted is a member of the House of Lords, formerly a member of the European Parliament and chaired the European Parliament's Economic and Monetary Affairs Committee from 2009 to 2014.

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