Clearing has become an early battleground in the UK's – and therefore London's – exit from the EU, but political posturing has been followed by calls for calm. Over the long term, however, nothing is being ruled out. Danielle Myles reports.

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It is Brexit’s €1300bn question: will London lose its status as a euro clearing hub?

In the days following the UK’s vote on June 23 to leave the EU, post-trade services were quickly identified as one of the City’s prized businesses most likely to decamp to the continent. French president Francois Hollande’s declaration that London could no longer dominate eurozone clearing made him the poster boy of the debate, but some bankers and lawyers – albeit with less fanfare – reached the same conclusion in hurried statements to the press and internal memos.

Several months later, the initial panic is over and the arguments more measured – not least because the outcome depends on the UK and EU’s revised relationship. But there are still significant discrepancies between how – and how drastically – market participants believe Europe’s clearing landscape will change, and whether politicians, regulators or the market itself will have the upper hand.

Why the fuss?

Considered to be the plumbing of financial markets, ‘clearing’ entails everything needed to get an executed trade to the point of settlement. This includes the transfer of payment and title, reporting, netting and any other activity needed to implement the agreement between the buyer and seller.

That process has taken on new significance since the G20 Pittsburgh Summit in 2009, when world leaders mandated that all standardised over-the-counter (OTC) derivatives – a major culprit of the global financial crisis – be cleared through central counterparties (CCPs), rather than bilaterally. While this has reduced counterparty risk, it means a huge amount of credit, liquidity and operational risk is located in these clearing houses.

UK-headquartered LCH and ICE Clear Europe have emerged as dominant forces in the clearing of euro-denominated derivatives. According to a recent note from Edmond de Rothschild’s chief economist, every year London CCPs process €1300bn of euro-denominated trades.

This has been a sore spot among eurozone authorities for years. Their best attempt at bringing this activity into the currency bloc was the European Central Bank’s (ECB) so-called ‘location policy’, which required CCPs with daily exposure of at least €5bn to be incorporated and operated from within the eurosystem.

EU authorities’ primary concern then (and now) appears to be derivatives, but the location policy did not discriminate between instruments. It was struck down by the EU General Court (EGC) last year, but its history of being challenged makes it low-hanging fruit in the Brexit fall-out.

Legal realities

When EU regulatory experts are asked about restricting where euro trades can be cleared, the response is emphatic. “There is absolutely no legal power that could be used to deliver this outcome at the moment,” says Simon Gleeson, partner at law firm Clifford Chance in London. “It would just about be possible to say no EU bank can clear on a non-EU CCP. But to do it currency by currency, and say you can clear dollars outside the EU but not euros, the legal powers just don’t exist.”

EU bank restrictions would need to be imposed via the European Market Infrastructure Regulation (EMIR), but currency-specific rules would require significant amendments to the Treaty on the Functioning of the European Union (FEU Treaty) and the strong support of the European Commission (EC).

The latter would be no mean feat. The EGC annulled the location policy because it incorrectly classified clearing as part of the eurozone payment system, which the FEU Treaty entitles the ECB to regulate. Compared with its foreign counterparts – even the US Federal Reserve – the ECB’s presumption was bold.

“A lot of central banks would agree that it is wrong for part of your payment system to be operating outside your territory, but I think the idea that derivatives clearing is really a sub-division of payment is pretty unique to the ECB,” says Mr Gleeson.

What is more, if the FEU Treaty is extended, it would entangle not just the UK but any other country with a large volume of euro clearing – notably the US by virtue of the CME Group, which houses one of the world’s biggest derivatives clearing operations.

“I’m not quite sure what would happen if the ECB or Europe more generally tried to dictate to [the CME Group] what it can and can’t clear. You’d imagine they might get a rather cross phone call from the US Treasury,” says Mr Gleeson.

A CME spokesperson says it is not possible to fully evaluate the longer term impacts until the terms of the UK’s future relationship with the EU are known. The Federal Reserve did not respond to a request for comment. 

Central bank co-operation

Central bankers are, however, likely to have significant clout in any decision. While politicians’ actions can change depending on the election cycle – Mr Hollande, for example, is facing a leadership battle and dwindling approval ratings ahead of next year’s presidential race – central banks have a more pragmatic and longer term agenda.

With more OTC derivatives being pushed through clearing houses, one of their chief concerns is the safety and stability of CCPs.

“How do you assure that? Not through political fiat,” says David Clark, chairman of the Wholesale Market Brokers’ Association. “You do it through central bank co-operation. And I have every confidence in that co-operation and that their hand, at the end of the day, will be the most important hand behind what happens with euro clearing.”

Some senior EU central bankers have waded into the debate. In a July speech, the Bundesbank’s Andreas Dombret said that allowing such a large amount of euro clearing to continue outside the EU is “a level of tolerance I can neither imagine nor support”. Two months earlier, Banque de France governor François Villeroy de Galhau said on national radio that if the UK leaves the single market, it would have ramifications for clearing.

But, perhaps more importantly, the eurozone’s overseer has been coy. “The silence on this topic out of the ECB has been noticeable,” says Mr Gleeson.

It is regarded as too sensible to get drawn into the debate and more realistic, given its first attempt to move clearing failed. The Bundesbank and Banque de France declined to comment, while the ECB didn’t respond to requests to comment on this article.

Around the world, foreign currency clearing is supported by a network of swap lines between central banks. It means that if a CCP runs into problems, its central bank can provide liquidity in the relevant currency at any given time. The ECB and the Bank of England expanded their swap line last year after the EGC ruling, and there is some speculation whether Brexit means the ECB could seek to renegotiate that agreement.

However Mr Clark, a 40-year City veteran, does not expect this backstop arrangement to change. “It’s almost inconceivable that central banks would take swap lines away from one another,” he says.

“Irrespective of the outcome of Brexit talks, central banks are very keen to ensure that CCPs are, as far as possible, subject to resolution and recovery and that there is plenty of liquidity in the CCPs to cope with any market dislocation.” 

A twist on the US model

Legal and policy barriers to restrict euro clearing mean changes in the short or even mid term are unlikely. But comments by Valdis Dombrovskis, the new European Commissioner for financial services, suggest there could be an appetite among the EC’s upper echelons for such a move in the future.

In July, Mr Dombrovskis told an audience in Washington, DC, that euro clearing is not the highest item on his agenda, but “one cannot exclude that this issue won’t be put back on the table”.

Despite downplaying the issue, his statement has not gone unnoticed. “He and a whole swathe of national regulators have made the assumption that at some point there will be a move to protect the euro-denominated side of clearing after Brexit. It seems like it is probably going to happen, but no time soon; there are a lot of steps to be gone through before getting to that point,” says Radi Khasawneh of Boston Consulting Group. The EC declined to comment o the matter.

Given that CCPs have become systemically important and therefore highly politicised, British bankers warn against underestimating EU authorities’ willingness to take drastic measures. For example, the pan-European securities settlement platform Target2-Securities, or T2S, can only be accessed by non-EU banks through a local branch. Extending T2S to gain more oversight and control of clearing is not being ruled out.

Others note that the ECB’s location policy was struck down on a technicality. “The ruling is based on law, not necessarily based on the safety of the financial system,” says Diana Chan, chief executive of EuroCCP. The court did not consider whether the policy was an effective way to manage systemic risk, meaning its underlying principles have not been formally assessed.  

Following the dollars

Critics note that any clearing restrictions would be contrary to the euro’s status as a global currency; it should not matter where it is traded or cleared. The US dollar is held up as an example. In London alone, the bulk of LCH’s interest rate derivatives are dollar-denominated as is the vast majority of the London Metal Exchange's LME Clear business.

US bankers say their regulators are not thrilled about dollar trades being cleared offshore, but they cannot control whether another country decides to clear within its borders.

Instead, in classic American style, they tackle the issue via extra-territorial reach. Through a web of cross-border regulations US securities watchdogs have jurisdiction over the full spectrum of dollar activities around the world. EU authorities are not as powerful as those in the US and so must take a different approach – for example, by maximising the amount of euro business that occurs within their borders.

“For European regulators to say ‘hold on, for anything touching my currency I need to have a see-through’ is not very different from the US being able to penalise or fine anyone for doing anything US dollar-denominated anywhere in the world,” says Boston Consulting Group senior partner Philippe Morel.

He believes this is just another way for regulators to have full knowledge of the risks to which their currency is exposed – and CCPs could be just the tip of the iceberg.

“I think a whole scheme of regulation could very well appear in Europe, like it has in the US, to protect the euro as a currency for any activities – be it trading, clearing, lending and so on,” adds Mr Morel. 

A logistical nightmare

If this does happen, the more lead-time there is the better. Logistically, there is no tried-and-tested way to move clearing business cross-border from one CCP to another.

LCH and ICE Clear Europe – the two biggest euro clearers outside the eurozone – have CCPs registered in France and the Netherlands, respectively, so it is possible that they could transition their open-interest pools (derivatives contracts that have not yet settled) to those affiliates.

However, it may not be as simple as booking trades to a different legal entity. The recipient CCP must have the sufficient capital, infrastructure and licences to handle more trades and possibly different products.

Also, most derivatives that use the International Swaps and Derivatives Association master agreement are governed by English or New York law. Lawyers note that transferring that trade to Paris, for instance, means the end user now has French law clearing exposure.

Another option is for clearing members to move their business from one CCP to another. There is one example of this: in 2014 LME migrated all of its contracts from LCH to its newly established clearing house, LME Clear. The process completed 15 months after it was agreed.

Despite this benchmark, no one favours transferring open contracts piecemeal. It would mean dismantling product-specific liquidity pools, netting arrangements and billions of pounds in initial margin and guarantee funds.    

If London is stripped of euro clearing – whether through a location-style policy or expanding T2S – Mr Gleeson says financial firms will suffer significant collateral damage. They may have to change custodians and settlement arrangements, which would be a costly task, but more significantly, for derivatives they would have to post more collateral.

Too expensive?

If positions are split between venues – with euro trades cleared by one CCP and dollar trades by another – they lose the netting efficiencies of using one CCP. This type of fragmentation quickly becomes an expensive proposition.

“The open interest that exchanges and clearing houses enjoy is a huge draw that’s almost impossible to break,” says Roger Liddell, former group chief executive of LCH.Clearnet. "Even if you had a new competitor with lower prices, the fact that participants would have to post more margin by splitting their business makes it very difficult to move.”

This would rub salt into the wound for clearing banks. Tough new capital charges have caused a number of them, including Nomura and RBS, to exit OTC clearing over the past 12 to 18 months, while Credit Suisse has outsourced its business to a post-trade facility.

“The argument for it as an add-on business is depleted because of the capital requirements, and it’s very difficult as a business on a standalone basis to make money. It’s actually a very difficult time across the clearing landscape, particularly for the banks that act as intermediaries,” says Boston Consulting’s Mr Khasawneh.

Requiring euro clearing to occur on the continent could prompt more banks to stop certain business, or move the clearing of other currencies as well, to minimise the collateral they need to post. “There is no slack in this system – no one can afford to say ‘it’s only a bit more capital, we can afford to take the hit’ because they can’t,” says Mr Gleeson.

That said, wholesale changes would not be based solely on capital charges. Other factors such as tax and staffing will be considered, along with how large a firm’s euro operations are compared with its overall clearing business.

Brexit bridges 

The historic merger between Deutsche Börse and London Stock Exchange (LSE), which obtained shareholder approval in July, is heralded as an important link between EU-UK financial infrastructure. As Deutsche Börse owns Eurex, which houses a huge derivatives clearing business, and LSE has a controlling stake in LCH, the deal could have added another dimension to the clearing debate.

Its significance in relation to post-trade operations should not be overstated, as the deal terms make clear that the CCPs will remain separate. Nonetheless, it is understood that the merged entity plans to build liquidity bridges for trading, clearing and settlement between London, Frankfurt and Milan (LSE owns Borsa Italiana and securities depository Monte Titoli).

The deal does face obstacles. It is the parties’ third merger attempt in 15 years, and their choice of London for the new company’s headquarters has, post-Brexit, drawn vocal opposition from Felix Hufeld, the president of German financial regulatory authority BaFin. Anti-trust critics also view the new entity as being too big, including in the clearing of derivatives. Yet the merger would greatly improve the prospects of a capital markets union, one of the EC’s big tent policies.

A Deutsche Börse spokesperson acknowledges the many voices commenting on Brexit’s possible consequences for financial markets, including the location of clearing euro products. “We do not want to prejudge the decisions that politicians, central banks and regulators may or may not take in future. We will continue to be a key contributor to financial market stability and committed to be a partner of choice with our foundation in the eurozone," she adds. 

Commercial imperative

Irrespective of any mandated move, it is possible that clearing firms will choose to do more euro business in the EU, and the prospect of this has sharply divided market opinion.

“No one has the slightest desire to move these activities – the CCPs don’t, the clearing members don’t, the clearing customers don’t,” says Mr Gleeson. “There is no momentum here beyond that which the ECB manages to give it. What everyone would like is for there to be only one CCP in Europe, and for it to be in London.”

But others expect clearing firms to do more of their new euro business on the continent, to cater for EU-based end users who prefer a local CCP.

“Looking three to five years ahead – assuming Brexit takes place as a complete divorce – rather than euro clearing moving from London to say Frankfurt, I expect we will end up with two clearing centres,” says Mr Clark. "If you are a major non-European bank, you’d want to hedge your bets a little bit and you’d want to spread your risk by having clearing facilities on and offshore EU.” 

It is a prudent approach that avoids the mess of moving existing clearing arrangements. Of course, it would be easier for some firms than others. Many continental European banks, for instance, already clear much of their London trades across the channel and some US banks run their euro businesses from Frankfurt (which is considered a bigger potential rival to London than Paris).

Since banks need to plan five to 10 years in advance, it could be that these incremental changes start sooner rather than later. “Even if Brexit talks are still going on in two years, most banks will certainly have already increased their activities through whichever European legal entities they have,” says Mr Clark. “To the extent that will impact on clearing; yes it will, but it won’t close London down.” 

A matter of perspective

Euro-specific concerns should not overshadow a more tangible threat to London as a clearing hub: whether, and how quickly, the UK can obtain an equivalence decision from the EC under EMIR. This would be needed for UK-based CCPs to conduct business for EU clearing members and trading venues, irrespective of the currency involved.

The EU and US taking four years to recognise each other’s CCP regulations sets a dangerous precedent, but the UK’s compliance with EMIR to date suggests equivalence is not overly ambitious.

For EuroCCP’s Ms Chan, the ideal outcome is grandfathering, such that today’s clearing relationships continue unaffected and the incoming UK-EU regime applies only to new CCPs or those adding new clearing members. She is quietly confident that common sense will prevail, saying: “I don’t think existing arrangements will be prohibited, but it could mean a lot of paperwork to go through the authorisation process.”

As EU CCPs, clearing firms and end users want to maintain access to London – as a global capital markets centre with world-class financial infrastructure – it’s in everyone’s interest to not use EMIR as a pawn in negotiations.

On euro clearing, at the end of the day, Brexit must be viewed in context. “Frankly, I think the UK not joining the euro currency was a bigger event than it leaving the EU,” says Mr Liddell.

“For years now many authorities have felt that a non-eurozone country controlling an awful lot of euro-denominated activity is inappropriate, but that’s survived and perpetuated, and I think it still will.”

While political pressure is an established part of the clearing landscape, banks and brokers are less predictable. And according to Mr Liddell, they will have the final say: “Having worked in a company that had a base in Paris and London, I know that usually the financial markets themselves determine where they want to do business and not the politicians.”

London incrementally losing euro business to a handful of EU cities does, for the foreseeable future, seem a more realistic threat than treaty changes or a suite of rules protecting the euro. In which case, those that fear the City is losing its clearing lustre should take a good hard look at themselves and their post-Brexit plans.

 

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