Where will nearly €1 trillion-a-DAY in euro-clearing operations go? But other finance operations might not go to the usual suspects.

By Don Quijones, Spain & Mexico, editor at WOLF STREET.

The UK economy’s prize “asset,” the City of London’s gargantuan financial services industry, is at the top of the menu of the forthcoming Brexit negotiations. For Britain’s Prime Minister Theresa May, safeguarding the City of London’s operations is a top priority. But for the EU’s negotiators, those operations represent both a valuable asset to covet as well as a huge bargaining chip in the forthcoming negotiations.

One area of activity that European authorities, both political and monetary, seem determined to get their hands on, at pretty much any cost, is the City’s vast clearing operations.

The U.K. is estimated to handle 75% of all euro-denominated derivatives transactions, equivalent to around €930 billion of trades per day. It’s also home to roughly 90% of US dollar domestic interest-rate swaps. Clearing is a huge business for the City of London. The world’s largest clearinghouse for interest rate swaps, LCH, is based there and is majority-owned by London Stock Exchange Group Plc.

It functions as a middle man collecting collateral and standing between derivatives and swaps traders to prevent a default from spiraling out of control. As Bloomberg reports, the role of clearing houses like LCH in global finance has become far more entrenched since the 2008 Financial Crisis and the inexorable expansion of derivatives trading.

The ECB, together with the French government, have been trying to seize control of the clearing of euro-denominated transactions from the City of London for years. Ironically, it was the European Court of Justice (ECJ) — the same court whose jurisdiction the UK government is now determined to elude — that, in 2015, stopped that from happening on the grounds that the ECB cannot discriminate against an EU member.

But if the UK leaves the EU, and thus the ECJ’s jurisdiction, that ruling will no longer be applicable.

According to Manfred Weber, a Member of the European Parliament and close ally to Anglela Merkel, once Britain leaves the EU, it must give up the right to clear euros. France’s finance minister, Michel Sapin, agrees. “This goes to the heart of the resilience of our [financial market] arrangements and of our sovereignty over our money,” he told the FT.

They have a point. After all, if a euro-clearing bank fails, it’s the ECB that will have to pick up the pieces. As Graham Bishop, a consultant on EU integration and former banker, told Bloomberg, the ECB “would be crazy to allow these huge volumes of activity with the potential to create an issue of financial instability within the euro area to continue outside its control. Can you imagine the Bank of England allowing gigantic amounts of sterling being settled in the euro area? No.”

Now, in what the FT describes as a “legal fait accompli,” the European Commission is preparing to issue legislative proposals next month that would limit London’s ability to host euro-denominated clearing activities. However, any attempt to move euro clearing away from London to the continent is likely to take years to implement, be hugely disruptive, and ramp up costs for companies across the region.

LCH was already required by its regulators to hold $83 billion of collateral at the end of March. London Stock Exchange Group Plc CEO (and former Goldmanite) Xavier Rolet estimates that a Eurozone clearinghouse would have to demand $77 billion of initial margin if it took over the clearing of LCH’s current euro-denominated swaps portfolio, and LCH held on to the other currencies.

Other trading and clearing businesses may also follow in their wake. If the benefits of scale from having their first or second HQs in London are diminished by having to move roles to Europe, banks may look to shrink their London operations even further. Some are already planning to do so. The City of London could lose up to 100,000 jobs in a worst-case scenario, warned Rolet. That was in October last year. By January, Rolet’s worst case scenario had got a whole lot worse: 232,000 jobs were now on the line, as well as overall market stability.

But where would the jobs go? Frankfurt? Paris? Luxembourg? Dublin? Amsterdam? Madrid? Milan (whose own financial sector is hanging by a thread)?

All of these cities are desperate to take a piece of the City of London’s action. Given that proximity to major seats of political, judiciary and regulatory power is an essential source of competitive advantage for major financial institutions, London’s most likely heir apparent is Frankfurt. It’s already home to the ECB and has also launched a bid to become the future host of the European Banking Authority, currently based in London.

But according to some, including Rolet, the biggest benificiary of London’s prospective demise as the world’s clearing capital is likely to be none of the above. In fact, it wouldn’t even be a European city.

Rather than moving their workforces en masse across the English Channel, banks are far more likely to move entire departments that can operate from just about any time zone, including those with global-facing roles in merger advisory, trading and back-office technology and finance, across the Atlantic.

“There is no way in the EU there is a center with the infrastructure or regulatory infrastructure to take the role London has,” particularly in capital markets, says John Nelson, chairman of Lloyd’s of London. “There is only one city in the world that can, and that is New York.” By Don Quijones.

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