There May Be a Huge Brexit Fight Over Financial Plumbing
London is a global clearing hub and trillions of dollars flow through the capital every day
Britain will have many contentious skirmishes during its negotiations to leave the European Union. But one, deep inside the financial system’s plumbing, is shaping up to be especially thorny. It is about the clearing of securities. London is a global clearing hub, and trillions of dollars flow through the capital every day. Will London lose this crown? And what will it mean if it does? Here’s what you need to know, based on interviews with clearing executives, lawyers and consultants.
What is clearing?
A clearinghouse sits between the buyers and sellers of instruments such as bonds, commodities and derivatives. It gives buyers comfort they will get what they bought and sellers comfort they will get paid. To do this, the clearinghouse steps in between the two parties, pledging to complete the deal even if one side reneges.
Why is so much clearing done in London?
Clearing is a scale game and the City of London has heft, especially in derivatives. Last April, $1.2 trillion of interest-rate derivatives were cleared through London every day, in currencies including dollars, yen and euros, making Britain the second-largest clearing destination in the world after the U.S., according to the Bank for International Settlements.
Why does scale matter?
Scale saves money. A bank must hold capital against its trades to cover its risk. Let’s say a bank makes a bet with Client A that interest rates will rise, and a bet with Client B that they will fall. If a bank trades directly with the clients, both of those positions have risk and require capital.
Run through a clearinghouse, though, the bank has two offsetting bets with the same counterparty: They cancel each other out. Done over thousands of contracts, this netting results in a much smaller position.
Clearinghouses can also help banks “compress” positions, for instance by consolidating several trades into one.
The more contracts going through one clearinghouse, the more netting and crunching down of contracts can take place, and the more efficient it is for the parties who use it. London has benefited from this snowball effect.
How would Brexit affect this?
It could break up this pool of contracts.
How?
As part of the EU, the U.K. benefits from global agreements that make it easier for banks from around the world to clear through “qualified” EU clearinghouses, such as the London clearinghouses.
Brexit could see the U.K. frozen out of this system. Once it leaves the EU, the U.K.’s clearinghouses could lose that qualification. The European Central Bank could also withdraw its commitment to stand behind clearing in euros in London as lender of last resort. Global banks might then start going elsewhere, eroding the scale advantage.
Can the U.K. requalify?
In theory this should be easy: Most London clearinghouses already adhere to the same rules as their European counterparts, who themselves are already equivalent with other countries. But this could take time. It took the EU and U.S. four years to reach a deal on clearing. (People who worked on that agreement say the job could be done in months.)
So what’s the problem?
Brexit negotiations. European authorities might not be so eager to approve a clearing deal while other items are outstanding.
Qualifying is important. European rules are being rolled out to require that credit-default swaps and interest-rate swaps be cleared through qualified clearinghouses. Other products can be cleared through nonqualified clearinghouses but will be hit with a higher capital charge.
Is that all?
No. European authorities could try to force clearinghouses that handle large amounts of euro-denominated securities to be located in the EU.
Why would Europe want to do that?
Some policy makers are concerned about the idea that the U.K. would handle trillions of euros of derivatives while being outside the reach of the continent’s regulators or courts. Pushing trades through clearinghouses is a key part of Europe’s postcrisis market reforms.
London clears more euro-denominated interest-rate derivatives than the other EU countries combined—some 75% were executed in the U.K. last year. LCH.Clearnet Group Ltd. is the largest global clearer of euro-denominated interest-rate swaps. ICE Clear Europe Ltd. is the biggest clearer of euro-denominated credit-default swaps. Both are based in London.
There is another reason: If more clearing activity moves into the EU, then expertise and capital to back those trades would follow. That would bolster the EU’s effort to forge its own financial center.
How could EU authorities make this happen?
1.) Change the law. The European Central Bank could be given direct supervision of clearinghouses that handle lots of euro-denominated contracts. This could take years of political wrangling. A quicker solution: Apply thresholds to the amount of euro contracts “qualified” clearinghouses can process outside the EU. This could be tailored to be high enough not to affect the U.S. houses (which don’t do much euro business) but inflict pain on British businesses.
2) Cut off the Bank of England. The ECB could remove swap lines that provide emergency euro liquidity to the Bank of England. Clients might get cold feet when they realize their euro-denominated contracts aren’t backed by unlimited ECB cash. On the flip side, central banks don’t usually like to create financial instability.
3) Strike a deal. During the Brexit negotiations, the U.K. government could relinquish control of clearinghouses in return for something else. Whole chunks of clearing business could migrate to the EU, retaining that vital scale effect.
4) Hit the banks. The ECB could turn the screw on eurozone banks that use London clearinghouses. It could increase capital requirements for banks that clear euro-denominated securities outside the EU. Playing hardball could backfire, though. If locked out of London, EU-based banks might choose a bigger “qualified” venue—in New York, for instance—instead of Europe.
How onerous could it be to push clearing out of London?
Quite. Trades could be gradually moved from a London clearinghouse to a continental one, but there is still the substantial headache of reworking contracts written in English law into a host of European countries, each with different legal systems.
How big a threat is this to banks in London?
It is far from existential, but it could be costly. Major banks are already planning to build out subsidiaries in the EU after Brexit. This should give them local regulatory clearance to apply for memberships of clearinghouses on the continent. The cost and structures needed to then route trades through these entities remain a big question.
So how does this play out?
Bankers and clearing executives hope some sort of agreement will be reached under which any changes are phased in over a long time. Compromises could be found. Clearinghouses in London could register in the EU, for instance, allowing regulators there to have better oversight.
What about London’s position as a financial center?
Euro-denominated interest-rate derivatives accounted for a quarter of all the cleared trades in all the markets of the world last year. Much of that went through London. Finance executives say that cutting off euro-denominated trades alone probably isn’t big enough to turn the capital into a financial backwater overnight, but it could add to a cumulative effect.
What about jobs?
Clearing employs very few people directly. ICE Clear Europe, for instance, has around 80 people working directly on clearing matters. How their departure would reverberate through the network of lawyers and consultants who work with them is unquantifiable. Consulting firm Oliver Wyman estimates that exchanges, clearing and interdealer brokers generate up to £4 billion ($5 billion) of annual revenue and employ up to 12,000 people in Britain. They won’t all leave. The U.K. will continue to attract financial business thanks to English law, its language and time zone.