“Cliff Edge” Brexit Threatens $34 Trillion of Derivative Contracts: UK Regulator

A high-risk blinking contest no one wants to lose.

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

A messy, no-deal Brexit could throw 48 million insurance contracts and £26 trillion ($34 trillion) of derivatives deals into confusion. Nausicaa Delfas, head of international strategy at the Financial Conduct Authority (FCA), told delegates at a CityUK and Bloomberg event that there were “cliff-edge” risks due to uncertainty over the legality of financial contracts extending beyond the planned Brexit date, in March.

The UK government has already passed regulations that would allow European banks and insurers to maintain their UK operations under current rules after Brexit. So far, the EU has refused to reciprocate, even on a temporary basis.

The EU has also ruled out extending passporting rights to UK financial institutions after Brexit. These rights allow UK-based institutions to sell financial products from the City to investors in the 27 other EU member states. Brussels has also turned down the UK government’s latest proposal for a system of “advanced equivalence” between British and EU financial services.

If the EU continues to reject a temporary permissions regime and no cooperative Brexit deal is signed by the March 29 deadline, big doubts could be raised about the viability of certain derivatives contracts. And that could seriously disrupt an already highly volatile, deeply opaque, largely unregulated $600-trillion dollar industry.

The FCA is not the first regulatory body to warn of such an outcome. At the end of June, the Bank of England said that unless the EU accepted a temporary permissions regime for financial services, up to £29 trillion worth of financial contracts could be declared void in the event of a no-deal Brexit, of which around £16 trillion matures after March 2019.

In its Brexit FAQs handbook the International Swaps and Derivatives Association (ISDA), a global association for market dealers of over-the-counter derivatives, states that it is unlikely that Brexit will lead to a Force Majeure Termination Event, which allows for the termination of a contract or postponement of a party’s obligations or covenants. It does, however, highlight a number of other high-risk events that could transpire in the event of a disorderly Brexit:

  • “A Cleared Transaction Illegality/Impossibility event… could be triggered by loss of the ability for UK financial services firms to provide investment services cross-border into the EU.”
  • “A Clearing Member Trigger Event could occur if the loss of passporting rights causes the party which is the Clearing Member to be in default under the rules of an EU Central Counter Party Clearing House (CCP).”
  • “A CCP Default could occur if a UK CCP loses its rights to offer clearing services pursuant to EMIR (European Market Infrastructure Regulation), is not granted recognition pursuant to the third country provisions of EMIR… and the rules of that CCP entitle Clearing Members to terminate their transactions with that CCP.
  • The eventual market impact may result in additional Credit Events pursuant to the 2014 Credit Derivatives Definitions.
  • “Market movements could trigger increased margin calls or trigger provisions linked to ratings.”

It’s impossible to overstate just how important the clearings business is to the City of London, or for that matter how important the City of London is to the global clearings industry.

LCH, the world’s largest clearing-house, is based in London. It clears over 50% of interest rate swaps across all currencies, functioning as a middle man collecting collateral and standing between derivatives and swaps traders to prevent a default from spiraling out of control. The role of clearing houses like LCH in global finance has become far more entrenched since the 2008 Financial Crisis. London houses are estimated to handle 75% of all euro-denominated derivatives transactions, equivalent to around €930 billion of trades per day, and 97% of those in dollars.

Representatives for the City of London have called for a deal that preserves the status quo as much as possible. But the EU — and in particular, the ECB — seems more interested in wresting a larger share of financial clearing from London, something it’s been trying to accomplish 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.

The ECB has an obvious motive for seeking to wrest control of the euro-denominated clearing business from the City. In a post-Brexit scenario, the EU would be left with little influence over how clearing houses in the UK are policed once Britain leaves the single market. Yet if a euro-clearing bank failed, it would be the ECB that would have to pick up the pieces.

There’s also a clear commercial incentive at play. Eurex, LCH’s largest continental competitor, based in Frankfurt, announced last year that it would allow banks to share in the profits from clearing. Since then its daily cleared volume in interest rate derivatives has surged from €8 billion to €67 billion — the equivalent of roughly 8% of the global Euro-denominated interest rate derivatives market.

But as impressive as Eurex’s recent growth has been, it’s still dwarfed by London’s clearing operations, which are also growing. The future of those operations are still very much up in the air. If the last two years of negotiations are any indication, either side will be reluctant to back down in this gargantuan blinking contest that could have ugly reverberations far beyond Europe’s economy.  By Don Quijones.

The electronic-payments industry, which gets a cut from every electronic transaction, wants to kill cash. But wait…  Backlash Against “War on Cash” Reaches Washington & China

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  43 comments for ““Cliff Edge” Brexit Threatens $34 Trillion of Derivative Contracts: UK Regulator

  1. alicat says:

    City of London representatives? You mean the owners of the planet Earth?

    Burn baby burn.

  2. Joan of Arc says:

    $34 trillion seems like a big number until you realize that the total derivative universe world wide has an estimated notional value of over $1 quadrillion. That’s $1,000,000,000,000,000.

    The only other human creation that outdoes that on the planet earth is the 5 gyres swirling in the 5 oceans composed mostly of discarded plastic each the size of the State of Texas with an average depth of 300 feet.

    • ppp says:

      Actually, isn’t it about $11 quadrillion by now, or am I being conservative?

      • Wolf Richter says:

        $600 trillion notional value.

        • MooMoo6765 says:

          That $600 was a self-imposed cut in assessment brought about by the IMF itself when the banks reported (in 2007/8) that it was $1.14 quadrillion, and the system almost went into cardiac arrest. Magically… it was halved.

    • Mean Chicken says:

      ave. depth of 300ft, OMG…..

    • Tim says:

      Money is a fiction – that is to say that it is not really real – it is imaginary – but we all agree to pretend that the pieces of paper, circular metal and numbers in your bank account mean something. The plastic in the ocean however is real.

  3. Jim says:

    Trigger warning!

  4. kaj says:

    0/ Good Advisory, Don Quijones. Thanks.

    1/ Thought that the gyre circulation was a natural phenomenon; Plastic of course is a human creation.

    2/ Re: Argentine– Have complained several times to Wolf about his correspondent’s (ex FT writer) terrible neo-liberal bias, but to no avail/retraction. So where is Argentine now? On a funeral/funereal fire. See Naked Capitalism today.

    • Wolf Richter says:

      Argentina has managed to totally destroy its currency over the past 16 years (peso went from US$1.00 to US$0.03). Inflation in June was 30% annual. But now at least, the Macri government posts inflation numbers, which was illegal under the Kirchner regime because that regime didn’t want people to know what’s going on. This is the result of many years of terrible policies, corrupt governments, and reckless money-printing to pay for those terrible policies and the corrupt governments (the central bank is part of the Ministry of Finance). Much of this occurred under the rule of your personal heroine, Cristina. The IMF should have REFUSED to bail out Argentina the first time, and it should have refused now. NO ONE should EVER lend month to the governments of Argentina.

      Here’s my latest for you edification:


      • Petunia says:

        The IMF will continue to lend to Argentina because they have an abundance of one of their favorite assets, land. It won’t be long before Argentina is broken up into areas owned by some globalist structure.

      • raxadian says:

        Don’t forget the decades of military dictarships that destroyed the economy, the “uno a uno” and even more.

        The destruction of the Argentina economy has been a work of several decades, not just make the mistake of blaming the previous administration.

  5. Ambrose Bierce says:

    I don’t share the worry, derivatives come in two categories, interest rate and currency, the design of these things is crafted with the intent of securing cross border investments. Some derivatives are cancelled and no ones written which may provide a drag on risk since rates have moved higher but event catalyst, probably not.

    • Justme says:

      There is also Credit Default derivatives, such as the now famous Credit Default Swaps of 2008 fame.

    • JB says:

      I agree , as wolf has stated ,these contracts are stated at notional value that doesn’t represent counter party risk .

  6. Petunia says:

    Pure fear mongering, something we here in the US have a lot of experience with, unfortunately. I would rather be on the side that doesn’t have Brussels in it.

  7. Unamused says:

    The clock is ticking on the Brexit derivatives problem. Too bad it’s not solvable.

    Once the clock stops ticking it won’t be a problem any more. There will be other problems. Those won’t be solvable either.

    ‘Gyre’ is not a financial term and is therefore safely ignored. There is no real accounting for environmental assets, and that is a far bigger blind spot than the opacity of the derivatives industry. More than the mere target of merciless resource plunder, the natural world is also the sink for the global economy’s externalities, essentially civilization’s garbage dump, when it should be accounted as a grossly and irredeemably impaired asset. That’s not solvable either.

    Suicide is painless. That’s why it’s so easy.

    • Unamused says:

      The above is my reply to Joan of Arc.

    • sierra7 says:

      “….Gyre is not a financial term……..”
      You are so right! We take no margins for the horrible, destructive “externalities” of “unbridled” capitalism which in the not too distant future if not curtailed will prove the total destruction of humanity. This earth deserves a better future…..we don’t deserve it!

  8. cdr says:

    One of the constants I noticed over the years is that most of the worst financial scandals in the world had a London connection. My impression for the future is that the most of same people who favored London for their business ventures will not lose any sleep over Brexit. They will move to where ‘capital flows the smoothest’ and only the least prepared will suffer a small amount of indigestion over Brexit. The rest is for the newspapers and bloggers to contemplate.

    That being said, the EU needs money to pay for their socialist utopia. Google is a source for now (who should embrace their opportunity to support the EU with the requested fine, plus the toll to continue working in the EU). Other corporations will get the chance to join in soon, I bet. The financial crowd formerly from London will soon happily embrace the financial needs of Utopia in the EU. After all, Utopias aren’t free and unlimited printed money and debt monetization only goes so far.

    • Unamused says:

      ->That being said, the EU needs money to pay for their socialist utopia.”

      Which costs about the same as a capitalist dystopia, without the overhead, and doesn’t feature 8-year-olds clambering barefoot over industrial machinery, as was the case back when America was “great”, and will be again once the child labor laws have been “reformed”.

      ->After all, Utopias aren’t free and unlimited printed money and debt monetization only goes so far.

      Hence the occasional financial crash, needed to externalize certain accumulated costs related to financial distortions. After all, unlimited printed money and debt monetization are features of utopias for capitalists and are obvously incurred for their benefit, insofar as drones do not run national economies.

      • cdr says:

        “Hence the occasional financial crash, needed to externalize certain accumulated costs related to financial distortions.”

        Good point. How will the Socialist Utopia of the EU recover from the occasional financial crash?

        By printing even more money and monetizing it all, turning the dial way past 11? By soaking Google and the other brave new world corporations who also support Socialist Utopia in the EU with more giant fines for new infractions, plus higher fees just to do business in the EU? As they are fond of saying over there, The EU is Forever, at least until they start calling it Venezuela in a decade or so.

        Re Google and their future EU generosity: Well, if their employees like the idea of that kind of life here in the good old USA, to the point employees get marginalized if they have other ideas about anything, then embracing the need for corporations to pay for it all here and there is the logical next step. Thank you for your support. Sorry shareholders.

        • Tim says:

          In the good old days before socialism, there were two types of people – the rich, and the peasants. There was virtually no middle class. The peasants didn’t typically live past 30. Socialists (via Unions) gave you the 5 day work week, the 8 hour work day, medical benefits, paid vacation, work safety laws, and made it illegal for employers to beat their employees (something that actually used to be legal in the good old USA). That is only a partial list of what the terrible socialists did that you benefit from every day of your life.

  9. Kenny Logoffs says:

    Can’t you just buy insurance to cover this risk?

  10. nick kelly says:

    WR: as you have noticed I am something of a right winger or at least to the right of the Bolsheviks, but does capitalism need derivatives? Or anyway, derivatives in a number exceeding the global GDP.

    They almost got us once in the LTCM crisis, where the Nobel genii had wagered a few paltry billion but via derivatives had leveraged the threat into trillions.
    We know this complex system is going to go turbulent at some point.
    Do we need this other risk that could amplify it?

    Am I correct in thinking that the fundamental structure of our technology: electricity, TV, planes, computers etc. was created before derivatives became a big factor, i.e., without them ?

    Is it possible to separate basic futures and puts. that I believe are centuries old. from these multi- trillion dollar freaks?

    Or to put it another way, would capitalism be hurt if the more esoteric creatures in the financial barn were euthanized?

    • nick kelly says:

      Sorry: forgot it was a DQ piece. I realize you guys can’t reply to all but questions but if either feels like it…

    • Wolf Richter says:

      I think some things we get whether or not we need them. No one needs cryptos either, and we got them :-]

      More seriously, as you allude to, many derivatives serve a real purpose and are beneficial in a modern economy. But it’s hard to separate what’s necessary and what is just gambling or worse. The problem is that the system has gone bonkers, and everyone thinks that this state of “bonkers” is the new normal.

      • MooMoo6765 says:

        The Problem is a clearing problem… which is why people have always used proper exchanges, with clearing members. When everything became ‘bi-lateral’ OTC risk, the system was gamed (VAR), and no-one could assess risk across the board. THAT is why you need an exchange, and why it is OTC derivatives and not exchange traded Derivatives that pose the risk.

        …bring back open outcry.

        • fajensen says:

          Exactly Right –

          And That is why Central Banks bailing out OTC was just about the most stupid anyone Ever had! “Unregulated Market” must mean “You are on your own”, not “Don’t worry, Daddy’s got Credit, so why not have a go at the baccarat table?”

          By backstopping OTC, the ECB basically decided to making private gambling debt written up on notes by landed gentry in the smoking room (which is what “Unregulated Markets” means) into hard currency.

          They should have let OTC blow up! Those gambling gents could then have solved it the old ways with duels, swapping of land / wives / daughters and loss of good standing for not paying up.

          Society has many time proven methods for picking up the pieces left over from “irrational exuberance” – like bankruptcy proceedings, prison, wellfare, unemployment checks and job training; only when those are exhausted should one consider innovative ones.

      • sierra7 says:

        It’s like slicing Salami: You make the slices thinner and thinner and pretty soon, “poof”, no more Salami! (Salami represents the imaginative output of the “derivatives’ traders)

  11. Unamused says:

    ->Can’t you just buy insurance to cover this risk?

    Probably not. £26 trillion is more than half the global economy. £600 trillion is nearly ten times the global economy. Your insurance company might not survive it, so you should probably check the financial news before sending in that payment for your homeowner’s policy.

    You could hedge against it, but that would entail entering the Dark Alternate Reality of Security Derivatives, the financial equivalent of Mordor. No help there.

    Since there’s really nothing you can do to save yourself it’s pointless to worry about it. So go out and have some fun, and don’t skimp on the champagne.

    • MooMoo6765 says:

      …the insurance is self-sufficiency in a secure environment.

      …good luck with that…

    • Kenny Logins says:

      Your post sums it up, we have exposure beyond what is realisable, because of what are essentially insurance products piled on top of each other.

      While we’re insuring beyond our means or any sense of reality, we may as well keep doing it for a laugh.

  12. Mean Chicken says:

    If this isn’t proof BREXIT must occur, I don’t know what qualifies.

    • Unamused says:

      Brexit is easy, except for the financiers. It’s the multiple layers of entanglements. One imagines they’ll have plenty of time to sort out their various collections of tentacles once they’ve arrived at the bottom of the cliff.

  13. Gandalf says:

    Sounds like the trigger event for the next big Global Financial Crisis

    Britain is currently locked in this political death spiral where the leader of the Tories, the party supposedly in favor of Brexit, doesn’t really want to do it, and is trying desperately to do a soft Brexit that will basically be like turning Britain from a full state in the European Union into the Puerto Rico of the EU. Meanwhile, the party that should be against Brexit, since Brexit will cost jobs, Labour, has a leader that deep in his heart favors it.

    And of course, we now know that the Russians financed a huge amount of the UKIP Brexit Leave campaign, which pretty much tells you what they wanted to happen to Britain and the EU.

  14. Jim Graham says:

    And all along I thought that derivatives were a “simply complex” Ponzi game!

  15. safe as milk says:

    the way i look at it, it’s just a race to see what happens first brexit or the implosion of the european banks. either way, stick a fork in it, it’s done.

  16. raxadian says:

    All you need for a so called socialist utopia is high taxes, like in Scandinavia.

    Meanwhile the US charges an arm and a leg for their heath care, Internet sucks in many places of the US and the public education is really down the drain.

    All because of lack of regulation and enough taxes.

    But you love your tax cuts, don’t you?

  17. Ishkabibble says:

    The UK Elite are in full-blown panic mode — so much so that the so-called “Independent” has turned into a full-blown, bald-faced, anti-Brexit propaganda organ.

    Tony Blair is apparently going to be their point man (or vice versa) in their solemn mission to reverse the last referendum’s “error”. This is, of course, in addition to the Independent’s full-blown, years-long, anti-Trump-style propaganda effort against Corbyn.

    The closest thing I’ve seen in my life that compares to the way the western MSM behaves nowadys is how Pravda behaved during the cold war. Their only useful remaining service is that they reveal the mindset and goals of the Elite that controls them. You want to know what fairy tales and myths the Elite wants you to think and believe? Just read those publications. They can no longer be taken seriously by even semi-conscious readers.

    If the Independent doesn’t shape up very soon, it’ll end up in my “never look at it” category, right next to the NYT and WaPo.

    It’ll be very interesting to see how the Elite’s solemn missions evolve on BOTH sides of the Atlantic. In addition to bald-faced lying and false flag operations, to what other lengths are the Elite willing to go to get what they want?

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