It shouldn’t “create risks to the stability of the financial system,” which is soothing to know.
By Nick Corbishley, for WOLF STREET:
About 43% of the $9.4 trillion in daily global derivatives trades tracked by the Bank for International Settlements are executed in the U.K. A large chunk of them are euro-denominated, but some of those trades will soon have to be executed elsewhere, according to the Paris-based European Securities and Markets Authority (ESMA), which announced on Wednesday that once the Brexit transition period expires, on Dec. 31, trading in euro-denominated derivatives must remain within the EU’s jurisdiction or in a country with “equivalent” standards to the bloc.
From that day, EU investors will have to use a swaps platform inside the bloc, or based in a non-EU country that — unlike the UK — has been granted “equivalence,” such as the US. As a result, branches of EU banks in London will have to grapple with conflicting EU and British trading obligations. British counterparties will have to use a UK authorized platform, while EU counterparties will have to use an EU authorized platform, making a trade between the two sides impossible.
“The decision is a starting gun for a fight between the UK and the EU for the location of international derivatives trading in Europe,” said Michael McKee, a financial services lawyer at DLA Piper law firm.
Toward a Fragmented Market
The result will be a much more fragmented European derivatives market. That is likely to be bad news for the UK’s all-important financial services industry, which accounts for more than one-tenth of the UK’s tax revenues and one-fifth of its service exports. It may also impact investors and companies, whose financing costs may rise as a result.
ESMA acknowledged that the situation “creates challenges for some EU counterparties, particularly UK branches of EU investment firms.” On the bright side, it shouldn’t “create risks to the stability of the financial system,” which is a relief.
At this late stage in negotiations, the only way this rupture of Europe’s derivatives markets can be halted is through a last-minute deal that grants so-called “regulatory equivalence” to the UK’s financial services industry. Or failing that, a last-minute extension to the transition phase.
During the 47 years that the U.K. was an EU member, banks based in Britain had a so-called “passport” that allowed them to operate across the 31 countries of the EU and the European Economic Area without being subject to local regulation in every place they sold securities. This meant, for example, that a U.S. bank’s London subsidiary could sell interest-rate swaps across Europe without having to satisfy the regulatory and licensing requirements of each jurisdiction.
This was great news for the City of London, which by the 1950s had reinvented itself by becoming a haven of the “eurodollar” business, where other countries squirreled away their dollar-denominated earnings, often to evade U.S. oversight. In the 1990s, it became a big player in the booming derivatives business. By the end of that decade, most derivative deals denominated in the newly created euro were taking place in London’s Square Mile, where the necessary financial infrastructure and know-how already existed.
End of An Era
The U.K. has 2,079 investment firms that use such “passports,” compared with 703 companies in the other 27 EU member states combined, according to the European Banking Authority.
The chief executive of the International Swaps and Derivatives Association (ISDA) Scott O’Malia warns that a lack of equivalence could exacerbate liquidity fragmentation in Europe’s derivative markets, precisely at a time when markets would likely be facing considerable uncertainty resulting from Brexit:
Without equivalence, an EU and UK firm would find it challenging to trade a derivative that is subject to both the EU and UK trading obligations, because the EU derivatives trading obligation (DTO) would require the transaction to be executed on an EU-recognized trading venue, and the UK DTO would require execution to take place on a UK-recognized venue…
A similar conflict would emerge when an EU entity trades derivatives through its UK branch with a UK counterparty, and vice versa. These conflicts would create an impossible situation for banks, asset managers, pension funds and corporates that trade with counterparties in the other jurisdiction.
On a positive note, the UK and the EU have both given a certain amount of ground in recognizing each other’s central counterparties (CCPs) or clearing houses. The UK recently granted equivalence for clearing houses established in the European Economic Area (EEA), just over a month after the European Commission had agreed to temporarily grant equivalence for UK clearing houses
Losing the Crown Jewel
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. In many ways, it is the City of London’s crown jewel. The City is home to the world’s largest clearing-house, LCH, which clears almost €1 trillion in euro-denominated derivatives a day. More than four times as much trading in euro-denominated derivatives is handled in the UK as in France and Germany combined.
That London dominates financial services in euros, even though the U.K. isn’t part of the common currency, has long been a source of resentment on the other side of the Channel. Now that the UK is no longer even part of the EU, the ECB and certain European governments, with France leading the way, want a sizeable piece of that action, for largely justifiable reasons.
But the actual task of uprooting a giant chunk of an industry that took decades to build and then relocating it across the Channel, across multiple jurisdictions, is horribly complex. It means rolling over millions of often exotic financial contracts, some worth billions of pounds or euros, into a completely different jurisdiction with an entirely different legal system.
And the stakes could not be higher. As the German financial regulatory authority, BaFin, warned in 2018, getting it wrong could result in derivatives contracts, valued notionally in the tens of trillions of pounds, being thrown into confusion.
For the sake of market stability, the UK and Brussels reached a compromise agreement that allows clearing houses or central counterparties (CCPs) in the UK to continue serving EU customers for 18 months from January 2021. But it is only intended as a temporary reprieve, to give EU market participants (in the words of EU financial services chief Valdis Dombrovskis) “the time they need to reduce their excessive exposures to UK-based CCPs, and EU CCPs the time to build up their clearing capability.”
Now, as the final month of the Brexit transition phase looms, the rush is on among UK-based banks and other FIRE-sector companies to set up bases in EU cities, even as Covid rages across the continent, to minimize their exposure to any post-Brexit disruption. The City of London is licking its wounds, having found itself in the unfamiliar position of having its needs largely ignored by the government of the day. William Russel, the 692nd Lord Mayor of London, complained just this week that the UK government had “missed the point” of the City of London throughout the Brexit negotiations.
As all of this goes down, the biggest beneficiary of a fragmented European financial services industry could end up being London’s biggest global rival, New York, as EU bank branches in London turn to platforms in the U.S. that can cater to EU clients. But even that is likely to be riddled with legal and technical issues. By Nick Corbishley, for WOLF STREET.
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