Disorderly Brexit Would Trigger Mayhem in Derivatives Market

Time is running out. March 29 is the deadline. Urgent action is needed. But it’s not happening.

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

With less than six-and-a-half months to go before the UK’s deadline to leave the EU expires, progress is still lacking in the Brexit negotiations, in particular on crunch issues such as the Irish border and the equivalency of financial services. As the doomsday clock ticks down,  jitters are rising on both sides of the English Channel, particularly the English-speaking one.

On Monday, Moody’s said the probability of a no-deal Brexit has “risen materially,” and “would be negative for an array of issuers.” Such an outcome could bring with it a host of ugly consequences for the UK economy, ranging from a further weakening pound to higher inflation and sliding real wages, as well as undesirable knock-on effects for EU economies.

The longer the uncertainty drags on, the more likely it is that companies and banks will activate plan-B contingency plans, which in many cases involve moving a large chunk of their UK-based operations across the Channel. Once those plans are activated, stalling or reversing them will not be easy.

Deutsche Bank is mulling transferring up to three-quarters of the capital it has invested in the City — estimated to be worth around €600 billion — to its Frankfurt headquarters, the Financial Times reported on Sunday, citing sources close to the bank’s senior management. Tellingly, Deutsche Bank hasn’t made the move yet, since it knows that relocating key operations and staff across the channel is a costly, complex undertaking. It would much prefer to play a waiting game in the hope that the need for such drastic measures can be averted.

Most of the corporate moves that have taken place so far have involved small parts of firms’ operations, with few jobs lost in the City. But that dynamic appears to be changing as the Brexit deadline approaches. According to Risk.net, UK-based brokers and traders have already started activating contingency plans for a no-deal Brexit. Not even a last-minute agreement between UK and EU politicians will be enough to reverse those plans, they claim.

For the City of London, arguably its biggest fear is losing its hold over the global clearings business, which it has dominated for decades. Clearing is where a company acts as a middleman between financial trades, collecting collateral and standing between derivatives and swaps traders to prevent a default from spiraling out of control. London is home to the world’s largest clearing-house, LCH, which clears almost €1 trillion in euro-denominated derivatives a day, representing around three-quarters of the global market.

For City-based firms, the clearing business provides jobs and billions of pounds in annual profits. But those are now on the line. Euro-denominated contracts make up roughly a quarter of LCH’s daily volumes and with Brexit fast approaching, the ECB and certain European governments, with France leading the way, want a sizeable piece of that action, for largely justifiable reasons.

They’ll probably get it, said UBS analysts in a note last week. The analysts expect LCH to suffer a “25% loss of market share of the euro-denominated clearing market.” The authors also warn the clearing house will lose sales volumes “no matter the outcome” of Brexit, as “regulators like the European Banking Authority are encouraging institutions to prepare for a worst-case outcome to mitigate Brexit-related market disruptions.

This is spurring financial institutions to increase their business with Eurex, Germany’s largest clearing house, in a bid to reduce their Brexit exposure. The more customers Eurex attracts, the more competitive it becomes. Deutsche Bank shifted around half of its euro clearing volumes from LCH to Eurex in July. HSBC and Barclays also transferred volumes to Eurex earlier in the year, according to the FT.

In the UBS analysts’ best-case scenario, in which the UK and EU sign a provisional exit agreement by the March 29 deadline, LCH’s owner, the London Stock Exchange, will lose around 2-3% of its earnings per share.

In their worst-case scenario — a hard or no-deal Brexit — the resulting economic carnage could be huge. If the UK crashes out of the EU without any deal on future trading arrangements, it “would prohibit the clearing at LCH of ANY derivative contracts (not just euro-denominated contracts) by EU-domiciled entities,” the UBS analysts warn.

This doom-laden prognosis chimes with recent warnings by the Bank of England and the UK’s Financial Conduct Authority that derivatives contracts, valued in the tens of trillions of pounds, could be thrown into confusion by a disorderly Brexit. The London Metal Exchange (LME), the world’s largest market in options and futures contracts on base and other metals, has also chipped in, warning that its clearing house could struggle to provide services to European Economic Area (EEA) countries after Britain leaves the European Union.

Of course, these dire predictions could be construed as good old-fashioned Brexit fearmongering, which is in endless supply these days. But it’s no longer just the Brits who are peddling this narrative. So, too, is the German financial regulatory authority, BaFin, which recently exhorted EU officials to take urgent action to prevent mayhem in the derivatives market and insurance industry after Brexit.

“It is almost impossible to fix that problem exclusively just by one side of the stakeholders involved, let it be the industry itself or individual supervisors,” BaFin’s president, Felix Hufeld said at a forum in Frankfurt at the end of August. There has to be “a solution on a political level” aimed at building a legislative or regulatory structure to prevent disruption, Hufeld said.

Time is running out. Until now, the European Commission and ECB have shown scant willingness to accept any form of equivalency between British and EU financial services. And without that, there is a genuine risk that a disorderly Brexit on March 29 could set in motion an unraveling of an already hugely volatile, highly interconnected derivatives industry. By Don Quijones.

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  26 comments for “Disorderly Brexit Would Trigger Mayhem in Derivatives Market

  1. Gershon says:

    OT, but maybe if banks allocated a fraction of the funding to IT that they do for CEO compensation, they wouldn’t shaft their customers so routinely.


  2. Gershon says:

    With less than six-and-a-half months to go before the UK’s deadline to leave the EU expires, progress is still lacking in the Brexit negotiations, in particular on crunch issues such as the Irish border and the equivalency of financial services.

    They’ll find a way to kick the can. They always do.

    • Tim says:

      Definitely. There’s no way they will let the banks suffer. The people will be told to get stuffed, but the banks wont lose one penny.

      • AJ says:

        Theresa may will fix it.

        She got distracted by that poison in salisbury, but now she is full time on brexit and will definitely fix it.

        • Reddleman says:

          Wrong way round. Salisbury was a ruse to distract you the citizen, from the shambles that is her government.

          ‘Look! A squirrel! Not there, over there!’

    • KPL says:

      Yep! You have to hand it to the politicians, regulators and bureaucrats.

      They sure have mastered the art of scare-mongering and then striking a deal so that it will act as the cover for the deal (like the GFC provided the cover (the world would have come to an end) for the central bankers to launch their power grab and print money as they like and come preening about it a decade later-forget that it was a heist pulled on the tax-payers, savers, retirees and prudent people).

      That is the way to do it when you want to please your constituents.

  3. ewmayer says:

    When she hasn’t been exposing the outrageous shenanigans at CalPERS, Naked Capitalism’s Yves Smith has been consistently covering the UK’s inanity and delusion w.r.to Brexit. Here is a recent piece:

    Brexit: Circling the Drain? | naked capitalism

    Yves not generally known for overly dramatic dire warnings, so her take in the above is about as “extreme alarm” as you will see from her. Buckle up, folks, because the odds of a crash-out Brexit are much higher than reflected in nearly all the coverage by the MSFM, though some outlets are finally and belatedly starting to sound the alarm.

  4. William Smith says:

    Derivatives can be massively complex. Nobody can possibly have a handle on the interrelated nightmare that the whole thing has become. At some stage, an event will cause that house of cards to crumble. It might be Brexit or something else. Blaming Brexit for being a trigger is just ignoring the huge systemic problem of intertwined and massively leveraged complex synthetics that only “algorithms” can understand… or can they? Seems to me that the “quants” that design these systems have been proven guilty of heinous crimes of stupidity in the past. Politicians have no hope whatsoever of trying to understand such a mess, and much less of making sensible regulations to mitigate the risks. They must rely on “advisors” from the industry who have agendas incompatible with democracy and “free and fair” markets. It’s well past the time to start asking just how much of this complexity is really needed: or is it just a method of obfuscating “wealth transfer” (the article mentions billions in profits for this dubious “work”).

    • fajensen says:

      The sad agit-prop funnels we call news media likes to conflate the derivaties traded in the regulated markets with the OTC-trash paper+python code trading in the unregulated market (which is a lot more similar to the landed gentry’s gambling debts under Luis XIV than it is to investments).

      If people understood this, then people would ask: “Why are we bailing out theses r*t f*ckers estates on taxpayers money when health services etcetera are going down the drain over endless cost cutting”? That is why the two are conflated!

      This is a recent example of what happens when derivatives blow up in the Regulated Markets: https://www.bloomberg.com/news/articles/2018-09-15/phantom-trader-who-blew-a-hole-in-world-s-oldest-power-market

      — Not Much!

      Bailing out the OTC/ Unregulated Markets in 2008/9 was a stupid mistake of the ECB. If Brexit blows OTC out of the water, I think humanity will generally be better off for it!

  5. Laughing Eagle says:

    Derivatives were the cause of the 2008 crash. The Wall Street criminal banks and the Fed simply used the failing of Lehman as a diversion away from derivatives as the cause. They would do anything to avoid derivatives being regulated.
    Theses TBTF banks don’t lend to make money, their ill gotten gains are derivatives. They simply shift paper from one place to another and collect fees.
    Saying they had no legal authority to bail out Lehman but then had the authority to bail out AIG is a big lie.
    Warren Buffet, that two faced guy even has called them “weapons of mass destruction” and “time bombs”, and a “daisy-chain risk” meaning interconnectness of the counterparty in the contract to others along the chain.
    The 2008 crash only occurred within the canyons of Wall Street, not main street and local and regional banks who were not trading in those ultra-complex products.

  6. Peter Boardman says:

    If the British Prime Minister resigned would that diminish the “Mayhem”? Sorry…

  7. MC01 says:

    Margaret Thatcher famously said “If you lead a country like Britain, a strong country, a country which has taken a lead in world affairs in good times and in bad, then you have to have a touch of iron about you”.

    It seems that Theresa May lacks that touch of iron, just like here predecessors up to and including John Major. Her catastrophic handling of Brexit comes off at best like she’s grossly incompetent and at worst like she’s sabotaging the mandate she received from voters and taxpayers.

    The EU bureaucrats Britain faces are a whole lot like Mao’s reactionaries: paper tigers. They may do their best to look powerful and fearsome, but in reality there’s no much behind them, and they know it. They also know how to spot one of their own, and they know fully well Theresa May is another paper tiger, just like them. She has no bite and her cabinet is filled with similar spineless characters. I think it was Boris Johnson who likened the Brexit negotiation team to an army marching on the field of battle with raised arms and waving white flags. The scary thing is he may have been too kind.

    On top of this, let’s be charitable, leadership vacuum, Britain faces what I can only call a fifth column of the kind that’s become depressingly common in Europe over the last decade.
    This fifth column is an unholy alliance of big media, failed politicians and what people from Hong Kong would call “godfathers” which does its utmost to openly sabotage the democratic process. It’s one thing to be critical of the majority and quite another to actively work against the popular vote, like these people are doing.
    As I always say, if you don’t like the republican system there are many other government systems to pick from: the Kingdom of Saudi Arabia, the Islamic Republic of Iran, the Communist “Estado Novo” of China… just be careful that there going against the tide may cost you your liberty or even your head.

    • MCH says:

      Democracy does seem to be under attack all around, but given the interests of the various parties, ranging from banks, to the media, to the corrupt politicians, it’s not surprising that good intentions are getting subverted and turned into talking points against it.

      Brexit seem to be a startling example of how no one gives a damn about the people. The EU seem hellbent on punishing the Brits and setting an example to the member states on why leaving is frowned upon. They also don’t seem to give a damn that in punishing the UK, they will likely end up hurting themselves. The same politicians, media, etc can always point to the fact that the Brits are even worse off.

      As silly as it sounds, the so-called elites around the world has no idea why ordinary citizens would vote to leave the EU, or why the US elected someone like Trump to be president. It feels a lot like the last desperate attempt by the masses to get control of the situation before everything goes to hell, and something truly horrible like a revolution starts happening.

  8. Jeremy says:

    There will be a last minute deal, it’s what the EU does. Super late night “dinners” and thrashings out of things.

    See: Greece

  9. Kenny Logoffs says:

    1 trillion euros a day is sent via the city?

    What exactly is going on here?

    Over time, whose money is being diminished to allow the skimming off that activity to sustain the shitty of London?

    I have a feeling brexit is being setup as a blame-vehicle for more robbery of the plebs, across Europe.
    EZ gets to print to bail some more countries and kick the can.
    The UK can do the same.
    And the big debt monster vampire can keep feeding a bit longer on the borrowed output of said plebs.

    I wouldn’t be surprised if being terrible is the UK governments current mode of operation to cause this chaos.
    If the house of cards fell while it appeared they were in control people would look to the banks for the failure looming, not the politicians.
    Politicians apparently following the will of the UK electorate… ha!

    • Reddleman says:

      ^^ This ^^

      Well said Kenny.
      There is a line of thought that said that we have Brexit, because the City didn’t want to be constrained by EU law. Now, the article intimates that the city may suffer due to Brexit.

      Let’s take the big view, which is that the city gets what it wants from Whitehall, and the citizenry be damned.

      We perhaps only have a Brexit at all, because the city wanted it. If the city changes its mind, expect a second referendum.

  10. Covey says:

    I should imagine that the UK regulators and BoE would be quite happy to see the back of Deutche Bank and it’s toxic pile of derivatives. When that pile detonates the fallout will be horrendous and better that happens inside the EU rather than London.

    When Lehman failed the UK regulators were left to clean up the mess of Lehman UK because Lehman US had withdrawn all the cash balances of the London bank before filing for bankruptcy, leaving Lehman London instantly insolvent. That mess took many many years to unravel and did the reputation of London as a financial center no good at all.

    Regulators are supposed to have long memories!!

  11. raxadian says:

    The Eurozone and the UK really should stop playing this game if Chicken before both get their economies ruined due to this.

    • phusg says:

      Ony one of the two needs to stop in a game of Chicken :-)

      The UK chose to leave, so why should the much larger and more powerful EU concede anything?

      > Jeremy: There will be a last minute deal, it’s what the EU does. See Greece

      True, but that was within the EU. I largely agree with this analysis https://www.theguardian.com/commentisfree/2018/sep/21/brexit-chequers-salzburg-irish-sea-customs-union and think they’ll end up reluctanctly going for the border in the Irish sea.

      Sure many Brits are pretty dead set against it, but I imagine they may end up seeing it as the lesser of all evils, especially considering keeping the UK borders intact through all this risks breaking them up anyway through Scottish independence. Somethings gotta give and I can’t see it being what holds the remaining 27 EU countries together.

      • desmond says:

        I must say the N. Ireland will fight tooth and nail to avoid separation from the uk … they have 10 mps who hold the balance of power of the uk govt.

        • phusg says:

          Absolutely right. Although at the same N. Ireland will fight tooth and nail to avoid separation from the Republic of Ireland through a hard customs border. It’s almost as if they don’t want a Brexit! (which of course they and the Scots didn’t vote for)

  12. xear says:

    “We had to extend the March 29th deadline by one year due to unforseen difficulties.”

  13. ML says:

    No deal wouldn’t or doesn’t bother those that voted Leave. But it would for those that voted Remain.

    Mrs May is in the Remain camp and her trying to broker a deal of some sort is a sop to the Remains.

    The EU cannot afford to concede or compromise for fear other member states would want out and expect the same terms. But the EU bureaucrats would like a deal of some sort otherwise the other member states are going to be mightily annoyed when they find they are not allowed to trade freely with the UK let alone have to accommodate yet more immigrants.

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