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.
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