Battle lines drawn over London’s role in euro clearing

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As the dust from Brexit settles, the battle over one of the City of London’s prestigious businesses is already escalating.

François Hollande, president of France, is the loudest voice calling for euro-denominated clearing to be conducted outside London.

Shaping the future of the City’s current dominance as a trading hub in eurozone markets during the post-Brexit era will be the debate and outcome of what are likely to be years of negotiation between the EU and UK. A key question is whether the City can retain access to the single market and remain the dominant financial centre for euro-denominated markets.

The threat posed by Brexit potentially strikes at euro-denominated finance in the UK in many ways, but a key concern surrounds the clearing of derivatives. Tools such as swaps help protect banks and corporations against interest rate and currency moves.

For London, clearing of swaps is a cornerstone of the City. Euro-denominated swaps trading represents a third of the global interest rate derivatives market, according to data from the Bank for International Settlements. The UK takes the lion’s share of the euro business.

“The potential impact for the City of London is that up to 69 per cent of its interest rate derivatives market could move to continental Europe after Brexit,” says Dirk Schoenmaker, senior fellow at Bruegel, a Brussels-based think-tank. He estimates that could be business with a notional value of $1.4tn.

The move would reactivate a policy attempted by the European Central Bank in 2001 and foiled by a UK court action. The ECB is putting out a cautious public line. Lawyers say its future depends on the UK’s settlement with the European Union, especially on access to the single market.

“In the absence of a solution being found at a political level, then UK entities providing cross-border services from London . . . will no longer have a passport,” says Peter Bevan, a partner at Linklaters.

Officials familiar with discussions in Brussels privately say the real target is LCH’s SwapClear, the London clearing house originally a construct of a consortium of big investment banks at the turn of the millennium. Now controlled by the London Stock Exchange Group, it is by some distance the world’s largest clearer of over-the-counter derivatives.

Even so, the closely-knit world of the city’s clearing business is acutely aware of the vulnerability of its position. “No one on the continent is particularly happy that London is the financial centre of Europe,” says one clearing house executive

One potential silver lining for the City is that it has historically prospered from misguided regulation being applied by other countries. In the 1960s the US passed capital controls to tax investment in foreign securities, creating the eurodollar market in London. Sweden suffered when it imposed a financial transactions tax in the 1980s.

A US bank based in London says the Hollande threat ignores the fact that to insist on a specific jurisdiction for currency clearing was “anti-competitive”.

Others note that the euro’s status as a reserve currency appears problematic.

“Euros are a freely tradeable currency, they are capable of being cleared in the US, Singapore and elsewhere. It’s not just a London thing, it’s not just a SwapClear thing,” says Simon Puleston Jones, head of FIA Europe, a derivatives trade association.

Peter Hahn, professor of banking at the London Institute of Banking & Finance, says any policy to pull euro-denominated clearing from London fails to take into account “where investors are and where they want to be”.

He adds: “Where the market is, lots of investors want to run through there. You have investors looking to do business in English law.”

No matter such arguments in favour of London’s status as a hub for eurozone trading, City-based clearing houses are concerned that an era of greater fragmentation beckons as politics dominates the industry for the foreseeable future.

For users, clearing is expensive but banks and brokers claw back some of that outlay by posting margin to back their derivatives trades at the same clearing house. This incentive to keep derivatives trades inside one clearing house is cost effective, an advantage for users that would erode should clearing houses split between a UK and EU jurisdiction.

“It would be very damaging and Balkanise the market,” says a former clearing executive. “One of the biggest benefits with swaps all in one clearing house is netting. If you peeled the euro out of the clearing house you will increase the cost of clearing and fragment the risk.”

Indeed, clearing executives at European banks that could benefit from the move say they have little desire to move their portfolios to countries in the EU.

Given such complexities, others see it as a French push with a more immediate aim — disrupting the planned merger between the LSE and Deutsche Börse. The deal to unite Europe’s two largest financial centres is one that officials in Paris have publicly opposed.

However, Europe has long tried to attract business away from London, without success. Now it sees a chance.

“The passport issue is crucial. Without it you could see the shift,” says Mr Schoenmaker.