Why clearing matters to the City of London
European efforts to grab valuable business from UK alarms markets
European efforts to force the business of clearing euro-denominated derivatives into the EU as Britain prepares to leave pits the will of politicians against that of the market.
This unflashy, but critical part of financial markets, has become a key battleground as it threatens to erode one of London’s great strengths and a key part of the City’s success over the past decade.
What is euro-denominated derivatives clearing?
Derivative instruments such as swaps are used by companies and financial services companies to protect against adverse interest rate and currency moves. The risk management of derivative agreements, which can stretch for months or even years, is conducted via a clearing house. They are independent parties that sit between the two counterparties in a trade and are tasked with managing the risk if one side defaults on payment.
How big a player is London?
London clears around three-quarters of all euro-denominated derivatives. The UK capital also leads in clearing other derivatives such as currency swaps. It has also been a big beneficiary of a surge in inflation swaps clearing in recent months.
That said, London has lost a little of its sheen in recent years. The persistent low level of interest rates in the eurozone left daily turnover for interest rate swaps clearing in London down 12 per cent to $1.2tn by April of this year 2016, compared with 2013, according to data from the Bank for International Settlements. That saw the US rob the UK of its crown as the world’s leading hub clearing for interest rate derivatives.
Potentially skewing the figures is the fact that swaps clearing is mandatory in the US, but still coming into effect in Europe.
Why is the industry concerned?
The fear among users of derivatives and the customers of clearing houses is palpable, and not restricted to the UK. Last week, for example, the head of the US derivatives watchdog said it was “a mistake to restrict where clearing can occur”.
Banks prefer to keep as much of their derivatives portfolios together, making management of them more efficient and keeping costs down to end users.
Companies and financial institutions that use swaps may want a complex product that involves multiple legs in different currencies. As a result, the margin requirements for them may be in several currencies. Euro-denominated contracts may be collateralised with US dollars or UK gilts, for example. While swaps are cleared in locations around the world, London accounts for a hefty slice reflecting the attractiveness of the City and its legal system for investors.
London not only clears contracts denominated in euros and sterling, but the US dollar, yen and 14 other currencies. In Chicago, the CME has cleared €13.3tn of euro-denominated contracts over the past three years. Of the average notional $1.3tn in dollar-denominated swaps that are cleared every day, around $329bn is cleared outside the US, the BIS found.
Who would lose if clearing moved from London?
The clearing house offsets the margin requirements or can tear up redundant swaps deals, saving the industry billions in margin and capital requirements. So it therefore suits the industry to build up huge pools of capital. Forcing euro-denominated clearing into the EU would fragment those pools and raise costs.
Estimates vary as to how much more margin the industry would have to find although it could be as high as $77bn.
Ciaran O’Flynn, European head of bank resource management at Morgan Stanley, says fragmentation is a “daunting prospect”. “Looking at the increased margin and capital costs projections, those are big numbers. That is one area for derivatives where Brexit can be poisonous,” he told a conference held by Isda, a trade association last week.
Others have warned that efforts by the EU are tantamount to protectionism that would hurt the euro, the world’s second-largest reserve currency. “It could severely damage confidence in the currency,” said Intercontinental Exchange, a US exchange that operates one of Europe’s largest clearing houses.
And if it happens, others argue it could lead to the loss of thousands of jobs in the City, across trading, asset management, technology and data.