Wall Street people underestimated how nasty and political the struggle over the post-Brexit fate of European clearing houses would become. This week the European Commission offered threats to London-based clearing houses and inducements for their customers to move their trade to the EU.
Value of euro-denominated trades that clear through London each business day
UK negotiators in turn demand that euro derivatives clearing should stay in London. Serious money is at stake; about €650bn of euro-denominated trades clear through London each business day.
But are Brexit negotiators arguing over who gets to own a time bomb?
Clearing houses are not an object of nationalist or populist sentiment in the US. Americans who have given any thought to those operators of the IT and legal plumbing between buyers and sellers of securities and derivatives consider the clearing trade a complex, if profitable, business, with high fees for the specialists and lawyers who understand it.
Europe is different. The clearing-house business looms much bigger in London than in New York, Chicago or Atlanta. In particular, the clearing of euro-denominated securities and derivatives is a big profit centre for the UK financial sector.
London-based euro transaction clearing employs only a few thousand directly. Even so, before Brexit, London’s lock on euro-denominated derivatives vexed Brussels and Frankfurt.
There is history here. During the 2011 European sovereign debt crisis, London clearing houses raised the margins required for trading edgier euro-area sovereign bonds. This was not a political move. Volatility in euro sovereigns had increased, so the clearing houses’ risk management programmes dictated that more cash or good collateral had to be posted.
This infuriated the Eurocrats who had thought they were in charge of crafting ever more brilliant solutions for the problems of Greece and other “peripheral” countries.
Since then, eurozone officialdom has fumed over the policy risks of “their” markets being traded in London. What if there were a political upheaval in Italy? Would the London clearing houses demand scarce cash and even scarcer collateral?
Also, there was the money not being made by home teams. There is a good argument to be made that forcing bilateral derivatives contracts on to clearing platforms has concentrated rather than reduced systemic risk.
It is inarguable, though, that the clearing houses have made big profits out of the transition. LCH.Clearnet processed $241tn of newly transacted (gross notional) interest rate swaps in the first quarter of this year, up 45 per cent on the first quarter of 2016.
EU and UK politicians are also driven by (probably inflated) estimates of the jobs at stake. London consultants talk about tens of thousands of jobs leaving, should the clearing houses decamp. European policy entrepreneurs talk of the “network effects” that clearing-house relocation could bring.
It is hardly surprising, therefore, that the UK’s negotiators have made it a priority to keep euro clearing in London after Brexit. Using the same reasoning, their EU counterparts are determined to take “their” share of those profits and jobs across the channel or the Irish Sea.
However, negotiating teams may have glossed over a point or two when briefing their political superiors.
Assume that the EU’s people win the diplomatic and legal arguments, and the clearing of euro-denominated financial transactions is forced (and induced) to move out of London. Then the clearing members (ie global financial institutions) will have to put up more capital and collateral, since they will have a reduced ability to “net off” their euro-denominated risk exposures against those in other currencies and locations. They will also have the costs and management time involved in setting up European back-office operations.
So Europe’s financial sector costs would increase. Unless, that is, the expenses of “re-shoring” London operations are offset by greater industry efficiencies, including reductions in national and EU regulatory burdens. That will be painful and contentious.
EU sovereign debt issuers, though, could have new forced buyers for their paper. The “re-shored” clearing operations would need more collateral to cover the margin requirements for euro-denominated derivatives contracts. That could be another €100bn of added demand for EU government bonds.
Still, what if something were to go wrong with liquidity and volatility in the euro sovereign market, perhaps even more wrong than in the summer of 2011? As systemically important institutions, clearing houses such as LCH.Clearnet might require support from the Bank of England.
As one clearing expert says: “LCH.Clearnet is the biggest shadow bank in the country, and its open interest is bigger than the Bank of England’s balance sheet. The bank has an unlimited swap line for euros from the ECB, but then the UK taxpayer would be on the hook. If I were Mark Carney [Bank of England governor], I would much rather see the ECB address such a problem.”
London institutions have done well out of clearing euro-based transactions. After Brexit, the contingent risks for the UK public may be greater than its negotiators think.