The EU’s attempts to drive euro derivatives clearing out of London post-Brexit are doomed to fail

The EU’s attempts to drive euro derivatives clearing out of London post-Brexit are doomed to fail

London’s status as a global financial centre goes well beyond being justified by the size or influence of the UK’s economy. London’s critical mass in the trading and clearing of over-the-counter (OTC) derivatives and related underlying instruments has reinforced its status as the pre-eminent financial centre in the European time zone and it has naturally followed that the support infrastructures of trading have evolved here.

The English legal system and the wide acceptance it enjoys globally have also helped. This applies no less to euro transactions than to those in the dozen or so other currencies that are also traded in London’s OTC derivatives markets and by market participants who typically prefer to clear the consequent trades in London.

In spite of London’s powerful position as a financial centre, the UK’s ambivalence towards the EU – and perhaps especially its decision not to join the euro – had already, long prior to the Brexit vote of June 2016, led to various EU initiatives to require that euro derivatives clearing, where conducted in the EU at least, should be conducted within the Eurozone.

Note here that EU authorities such as the European Central Bank (ECB) believed themselves to have competence in making such rules for EU states or, importantly, ‘single market’ members. The approach taken with non-members focused on ‘equivalence’ and this is what was negotiated by the USA and others (see below).

This campaign came to its apex in July 2011 with a pronouncement from the ECB that all infrastructures handling euro transactions should “be legally incorporated in the euro area, with full managerial and operational control and responsibility over all core functions for processing euro-denominated transactions, exercised from within the euro area”.

The UK Government acted swiftly and commenced legal action at the European Court of Justice against the ECB on the basis that it was seeking to act outside of its powers as well as on two other related technical issues. In March 2015, the ECJ found for the UK on the first point, which obviated the need to judge on the other two matters.

The judgement stated: “The General Court holds that the ECB lacks the competence necessary to regulate the activity of securities clearing systems as its competence is limited to payment systems alone by Article 127(2) of the FEU [Functioning of the EU] Treaty.”

It was evident to many that, even in spite of the March 2015 judgement, the issue would reappear at some stage, with or without Brexit. On 29th June – only three working days after the Brexit referendum decision – President Francois Hollande of France stated: “The City, which could handle clearing operations in euros thanks to the UK’s presence in the EU, won’t be able to do them anymore.”

Francois Villeroy de Galhau, Governor of the Bank of France and a member of the ECB’s Governing Council, could only wait 24 hours before saying that “clearing cannot be located in London without following EU rules” – the haste here being more interesting than the content!

The European Securities and Markets Authority has, since early 2015, granted equivalence to no less than 22 CCPs (‘central counterparties’) from 10 non-EU countries for clearing, mostly of OTC derivatives. The countries concerned include South Korea, Japan, Mexico and of course the USA.

The equivalence determination for the USA was the result of a lengthy negotiation over nearly four years. It is hard to see how a prohibition of central clearing of euro-denominated products by CCPs located outside the eurozone would not require renegotiation of the existing equivalence determinations mentioned above, country by country, and a change to or even cancellation of the arrangements for those non-EU CCPs already approved – notably those in the USA.

In terms of liquidity, combined markets are always greater than any sum of parts. Splitting clearing would fracture markets and thereby, almost incontrovertibly, reduce liquidity precisely at a time when liquidity and depth of markets has become a source of global concern. Any irrational fragmentation of clearing will increase costs for end-users, increase capital requirements for Financial Institutions and Clearing Members as well as reducing netting and compression opportunities.

These outcomes would be at best seen as perversely unhelpful in light of the G20’s firm commitment to global systemic risk reduction. Since September 2009 the G20 has regarded deployment of CCPs in the OTC derivatives market as being central to its systemic risk reduction strategy. It is obvious that in this regard the fewer and more ‘central’ the CCPs are, the better.

It is worth remembering here that the euro is one of the major reserve currencies globally, in fact second only to the US Dollar. To prevent non-EU centres from clearing euro denominated derivatives would be politically and legally difficult, especially if such a restriction were to apply just to London and not to other centres. To prevent the clearing of euro derivatives anywhere outside the EU would, most experts agree, require the imposition of capital controls at the EU’s boundaries, which is politically impossible.

If Brexit results in the UK leaving the ‘single market’ as well as the EU then the EU authorities would have no jurisdiction over who transacts what and how in London. Only a denial of ‘equivalence’ in these circumstances would make life difficult for London clearers.

Furthermore a ‘singling out’ of the UK for denial of ‘equivalence’ would seem arbitrary as well as sufficiently perverse diplomatically and politically to risk damaging the euro’s reserve currency status. If Brexit resulted in the UK remaining in the single market then it would become difficult for the ECB or others to revisit a decision already made by the ECJ last year.

As we stand, the operation and regulation of London clearing houses is in full compliance with EU standards and requirements. While political hyperbole continues to get a great deal of airtime, it does seem likely that things will get calmer and it will be hard to envision the UK’s CCPs not getting full EU equivalence. Realistically, perhaps, the greatest potential ‘hostage’ here might be the length of delay in granting equivalence – keeping in mind it took the USA four years.

While mentioning the USA and US dollar markets it should be said that given the English language and the convenience of English common law, it seems likely that London will remain the largest centre for US dollar clearing in its timezone. An EU refusal of equivalence for London would deny EU-based entities access to the efficiencies and liquidity available in London’s US dollar (and other third currency) markets.

It seems unlikely that President Hollande would have thought all of this through before announcing the death of euro derivatives clearing in London. In fairness to the French President, it is often the way in politics that the loudest voices turn out to be the least informed – and he is far from alone.