Post-Brexit finance fight puts everyone at risk

The post-Brexit war over financial services — and to what degree Europe can lure business away from the City of London — is far from over. The latest battle is derivatives clearing. But compromise is possible and would serve everyone best.
Set up in the aftermath of the global financial crisis, central counterparty clearing houses (CCPs) act as middlemen between institutions trading derivatives, minimising counterparty risk. So if one party were to default, CCPs should still have access to collateral and liquidity to prevent a domino effect of subsequent blow-ups, as happened when Lehman Brothers went bankrupt in 2008. Though not big money spinners per se, CCPs are part of an industry that surrounds more than $1 quadrillion worth of derivatives.
The EU wants to gain control of this key cog of financial plumbing, which has long been London’s crown jewel and a symbol of its primacy in the sector. There is really only one name in the clearing game: Britain’s LCH Group, the largest interest-rate swap CCP in the world, controls 90% of the clearing in dollars, which is by far the most liquid and deepest market, and 90% of the clearing in euro derivatives.
Now that Britain has left the EU, that concentration is concerning for Europe. After losing a court battle to force all euro-denominated business to clear in the euro zone in 2015, the EU is raising the subject again — despite the UK’s central bank governor warning a fresh attempt would be “a very serious escalation.” Greater control of clearing would give the bloc more of a say in the event of a large default involving assets in euros. As it stands, it would have to rely on London — and crucially the Bank of England — to obtain access to euros from its own central bank.
But upturning the apple cart is not so simple. The situation is very different from the EU requesting that stock and derivative trading in euros by EU firms take place within its borders. A large chunk of dealing in shares and swaps moved seamlessly out of London at the start of the year. Forcing EU banks to clear derivatives in the euro zone, as well as forcing all euro business onto EU soil, could undermine the stability of the world’s financial system.
London has built a stranglehold on the complicated clearing process. Its expertise, common law legal system, convenient time zone and the scale of its broader financial markets have all made the UK the favorite among trading firms and investors alike. The two biggest European competitors to LCH, Deutsche Boerse AG and Euronext NV, are significantly smaller, handling only some currencies and maturities. It helps too that some of the world’s biggest investment banks — including JPMorgan Chase & Co and Barclays Plc — are able to exert some influence over LCH through their minority stakes.
But splintering LCH’s business by bringing some of it to Europe would not only raise costs — an issue some politicians may underestimate — it would also prompt dangerous fragmentation.
CCPs benefit greatly from scale. The ability to offset a wide combination of positions, held in different currencies and across maturities, at one clearing house reduces the amount of margin that firms need to put down. What’s more, in the event of a big default, multiple CCPs would need to work with each other, complicating a resolution. Individual clearing houses would also have less visibility into how solid a single party might be if positions were spread across multiple platforms.
And it’s not just a two-way tug of war. As Britain and the EU battle it out, it is actually the US that could benefit from a possible fragmentation. The US has been quite happy for dollar clearing risk to sit almost entirely in the UK, but its exchanges could gain from a potential break-up of Britain’s clearing hegemony, as happened with interest-rate swap trading. US clearing houses sitting thousands of miles away and with divergent rules enjoy access to EU business under under so-called equivalence, which at the moment only covers Britain until June 2022.
Europe would also face risks in forcing euro derivatives to move to the bloc. An unregulated offshore euro market could develop on its doorstep, leaving the EU with even less control. There are a number of precedents of the City benefiting from being outside the regulated perimeter, most notably the development of the offshore “eurobond” market since the 1960s.
And if the system ain’t broke, why fix it? The extreme market volatility during the pandemic has been a real-world stress test and the existing clearing houses — including LCH — passed without any noticeable wobbles.
If Britain and the EU can lay down their arms, there may be at least one adjustment that might appease Europe, make LCH sounder for everyone and keep London happy.
Under the existing regulatory framework, the European Central Bank could create a deposit facility for LCH, allowing the clearing house to post collateral directly at the ECB and granting the central bank greater control over euro business. It’s an arrangement LCH has been negotiating separately with the US to obtain access to dollars from the Federal Reserve.
Adding yet more complications to our delicate financial infrastructure is in nobody’s interest. Europe can best succeed in attracting financial services by being competitive — not by imperiling the stability of the system.

—Bloomberg

Elisa Martinuzzi is a Bloomberg Opinion columnist covering finance. She is a former managing editor for European finance at Bloomberg News