The UK knows well that the political ideology of Brexit can trump both economics and plain old common sense. What is less familiar is to see this phenomenon so clearly across the waters of the Channel.
As Britain battles supply chain problems in everything from petrol to poultry, Europe is facing its own sovereignty versus sanity trade-off — in the rather less consumer-facing world of derivatives clearing, where a Brexit negotiation that largely ignored the City and financial services has given way to an unhappy stalemate.
A memorandum of understanding agreed in March hasn’t gone anywhere, as tensions over Northern Ireland blocked progress. What was on offer was really only a talking shop. But no one has set up shop and there isn’t much talking.
But in the coming weeks, Europe will need to make a decision about one of few areas where it did grant temporary regulatory equivalence before Brexit, allowing activity to continue much as before: the ability to clear interest rate swaps and other over-the-counter derivatives in London, which is a global hub, through houses such as LCH, owned by London Stock Exchange Group.
The European Commission said, in the now-infamous “strategic autonomy” paper, that it considered the clearing of euro-denominated contracts by central counterparties outside the eurozone to present financial stability concerns. There was, it said, a “clear expectation” (not apparently a pun) that European banks should reduce their exposure to UK clearing houses.
This ambition has not really survived contact with reality. A report promised before the summer did not materialise, after conversations with the European industry highlighted the costs from an abrupt end to equivalence. “Everything is political,” said one banking source. “But we can’t be the victim of this approach.”
Derivatives clearing houses, the plumbing that sits between parties to a trade and helps manage defaults, work better the bigger their pool of transactions. It means better pricing and users can “net” their positions, reducing the collateral required.
About 90 per cent of euro-denominated interest rate swaps (or IRS, the main market in focus) by volume are cleared in London. But three-quarters of euro-denominated trades are between participants outside the EU.
EU banks also use London to clear non-euro currencies, like dollar or yen swaps. Preventing EU institutions from using London would create a small, uneconomic subset of the market, leaving them at a disadvantage to the rest of the world.
The stereotype of a politically driven tussle that would strip the City of lucrative business doesn’t really apply. The volumes concerned are only about 7 per cent of what’s handled on LCH’s SwapClear.
There’s a good chance some of that business wouldn’t move even if equivalence came to a shuddering halt next June: it would probably migrate to US banks that could route it back to London. There are also products cleared in London, such as oil, carbon and gas futures, that cannot be switched to the eurozone because those services are not on offer.
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This is part of the EU’s concern. Granting equivalence for 18 months was meant to give European capacity and infrastructure a chance to develop. Volumes cleared over Deutsche Börse’s Eurex are very slowly growing in IRS but its market share remains about 7-9 per cent, according to Clarus Financial Technology.
Were Europe to bring the shutters down, moving business would take several months — hence the mounting sense of urgency. The end of the year, six months ahead of the expiry of the existing equivalence determination, is seen as an important moment.
A permanent equivalence decision is politically unpalatable; a cliff-edge is economically so. The fudge would be a temporary extension with more language around the need for change. The European Securities and Markets Authority is doing a technical assessment of the systemic risks of third-country clearing, including the costs and benefits of relocation.
The UK’s flexing of its sovereign muscles hardly helps build trust that regulators and governments could work together constructively in future crises. And the European banking industry finds itself in a position familiar to British business over recent years: pleading for clues as to what might be required of it, how, and when?
Ultimately, relocation is unlikely to happen voluntarily and hacking off a chunk of a fundamentally global market would come at considerable cost to European banks and the capital markets that the EU is trying to strengthen.
Clearing will help determine whether the Brexit propensity to indulge in self-defeating behaviour cuts both ways.