EU is on a suicide mission trying to force clearing from the City to the eurozone

The Old Lady of Threadneedle Street has a reputation for calm and considered behaviour. Over the centuries, she has relied on her ‘eyebrows’ as a nuclear deterrent to indicate her concerns or indeed to punish miscreants.

Not any more. In a highly unusual move a few weeks ago, the Bank of England Governor, Andrew Bailey, didn’t so much as twitch the Old Lady’s eyebrows but rather pulled up her skirts to show some rather toned calf muscles. Bailey – who has some pretty mean eyebrows himself – said the Bank is ready to kick back against those deemed to be obstructing business or undermining UK financial services and risking financial stability.

The Governor was referring to the European Union’s demand that euro derivatives are settled by clearing houses within the eurozone – otherwise known as its ‘location policy’ – rather than through the City of London clearing houses. 

Such a move, he told the Treasury Select Committee, would be a “very serious escalation” in the current negotiations between the EU and the UK over agreeing new rules for post-Brexit financial services. More ominously, he warned that if the EU persisted with its policy, it would prompt a British response. 

He was reacting to the news that the EU has recently sent out letters to European banks, asset managers and other financial institutions asking them why they are still clearing in the UK, and what their plans are to move their euro clearing through their domestic markets rather than through the London Clearing House, one of the world’s biggest central counterparties.

Speaking to MPs, he said: “To get that by fiat would require something very controversial such as an attempt at extraterritorial legislation, or an attempt to force or cajole banks and dealers to say there will be some other penalty for you unless you move this clearing activity into the eurozone.”

He went on to point out that there could not be a worse time to take such a risk: “Clearing has come far more into the foreground as a financial stability tool since the financial crisis – a lot more instruments, particularly derivative instruments, are cleared now than before the crisis.”

Any erosion of the stability of the clearing system – which is global – “really would be a concern,” he added.  

So why has something so fundamental as clearing become such a bone of contention between London and the EU? And why is it so critical to financial stability? At its most basic, clearing is about managing risk. It is the mechanism in which a third party organisation, a central counterparty clearing house – or CCP – acts as an intermediary by assuming the role of both the buyer and seller of financial contracts and derivatives to balance transactions between those two parties. What the CCP does is to reduce the risk for traders by protecting both the counterparts to a trade – and the rest of the market – if the trader defaults on payment by acting as a counterpart to all trades. Ultimately, the clearing house is the guarantor if one party fails to uphold their part of the deal.  

To give a feel for the scale of what goes on within the LCH, its interest rate derivatives clearing service registered over $1,229 trillion in notional volumes last year while compression volumes saw $920 trillion compressed over the course of the year. The process of compression is important because it reduces risk, releases capital and oils the wheels of commerce.

The numbers are so mind-bogglingly huge that they are hard to imagine in physical form. But what they represent in real terms is banks and companies – and therefore the end customer – having a place where they can manage their risk. Although usually described as the plumbing and pipework of the financial system, clearing is better seen as the bedrock – the foundations – of the global financial system. And LCH provides much of the granite within that bedrock: in interest rate swaps alone it clears €927bn of contracts a day, which is roughly about 70% of the world’s volumes while Paris, one of the Eurozone CCPs, has just 11%. 

It’s no secret that Brussels has long had designs on the City’s euro clearing market, an essential part of the financial system’s trading infrastructure which handles trillions of euros a day. At the moment, the EU and the LCH have an equivalence agreement which runs until June 2022 and which recognises the UK’s CPPs as equivalent for supervisory purposes by the European Securities and Markets Authority (ESMA).(It’s one of only two out of 40 equivalence agreements that have been struck on financial services post-Brexit.)

If that agreement is not extended, then a quarter of euro derivative clearing would be forced to move to the EU because this is the amount which is carried out by EU firms on both sides of the trade. UK CCPs hold a dominant position for the clearing of euro-denominated interest rate derivatives and credit default swaps, with a market share of about 80% and 40% respectively.

At present, outstanding Euro denominated swaps are about £80 trillion, about a quarter of LCH’s total activity.  The other 75% of this euro-denominated business is carried out mainly by non-EU institutions which do not have an EU counterparty, and is dominated by the big US banks such as Goldman Sachs, JP Morgan, Morgan Stanley and Bank of America Merrill Lynch. 

Over the years, LCH has become the lynchpin in clearing because it has been able to offer highly efficient clearing services which are multi-currency ( there are 27 currencies) and across asset classes. Most of the users trade regularly in three to four of the big currencies such as the $, the yen, sterling and the euro, which is where 90 % of the liquidity resides.

What has changed over the last few months is that EU officials and politicians have come to realise that even if they gained 25% of the euro clearing market, this would be too small to be sustainable on its own to be a viable, liquid market: clearing requires big risk exposures and offsets for it to function most effectively. Which is why the EU is now said to be considering legislation to force other non-EU banks and firms which trade in euros to shift their business as well. 

It’s not only the Governor who fears for future financial stability if the EU continues with what is politely described as a ‘smash and grab’ protectionist policy. The world’s biggest banks – mainly the American ones,  which make up the bulk of the interest-rate swaps trading – are not happy either. Privately, they are saying they would resist any such moves to move clearing to the continent because of the costs but also the financial systemic dangers involved.

If clearing gets fragmented, the costs are going to shoot up for all parties. It’s difficult to be precise about the numbers but a study by Clarus Financial Technology Group estimated that if LCH’s business were to be split – if the euro clearing was transferred from London to within the EU – the initial margin requirement for traders would almost double from $83bn to $161bn. But this is only part of the cost because the process of moving from London to the EU would have a huge frictional impact on transactional costs.

The additional margin of $77bn would be borne by the banks, pension fund and asset managers, corporates such as Mercedes Benz or Siemens, and therefore, ultimately the public via higher prices or lower investment returns. One clearing expert close to the situation said: “Having to switch to other clearing outfits would make the collapse of Lehman Brothers look like a tea party. I bet Jamie Dimon (boss of JP Morgan) is already on speed dial to the Governor telling him that the EU’s plan to rip clearing out of London is sheer lunacy.”  It was LCH which managed to successfully resolve the $9 trillion notional interest rate swap portfolio of the defaulted bank from a portfolio that comprised more than 66,000 trades. SwapClear resolved the default in three weeks, and with no loss to other clearing members. By contrast, none of the Eurozone’s CCPs have the capability or expertise to manage a default of this scale.

He went on: “The EU’s politicians just don’t understand that LCH provides the most liquid and efficient market and no one wants to see this fragment across Europe. Plus, there are more US interest rate swaps traded in London than in the US so London is essential to financial stability.” 

What’s more, experts are concerned that if the clearing process were to be fragmented, this would result in less liquidity. “The EU, the EC and the ECB would be cutting off their own face to spite the UK and playing fire with their own risk management systems.” It is also inconceivable that the US would not respond to extreme extra-territorial regulatory overreach. 

Bailey’s intervention was indicative of just how delicate relationships with the EU’s politicians and officials have become.  Maraig McGuinness, the financial stability and capital markets commissioner, is leading the charge which is being driven by the French who hope to gain the most. The source added: “It’s a suicide mission: they are trying to create a captive market rather than the current global market. If there is a smaller pool of clearing liquidity to absorb any losses, risk would therefore increase not decrease. Is the EU going to try the same with the Japanese and US authorities? It’s nuts.”

But the EU’s argument is that now the UK has left the single market, ESMA will have less influence over how the clearing houses in London are regulated and scrutinised, and that the consequences of any failure of a London clearing house would have an impact on financial stability within the eurozone.

While this is an understandable concern, it is also disingenuous at best because the EU regulator, ESMA, already has supervisory oversight of LCH along with the Bank of England. Observers suggest that there is no question that LCH and BoE would continue to provide full transparency on the risk positions of EU firms across all currencies.

Yet ironically if there is a fracturing and fragmentation of clearing, the authorities – ESMA, EC and ECB – would actually have less information. Among the many reasons that  London has established itself as the dominant financial centre in all types of currency denominated financial instruments from equities to bonds to repos are the City’s high regulatory standards, the practice of English law and the UK insolvency regime.

Why, then, is the EU so determined to rip the heart out of a market which works so well for banks, asset managers and customers and therefore the stagnant European economy? Some say that EU regulators are still smarting over LCH’s role in the eurozone’s sovereign debt crisis in 2011 when it raised its margin requirements on debt for Spain and Ireland, otherwise known as a haircut. 

It was this haircutting that prompted the ECB to attempt to insist that all euro trades were done inside the Eurozone. But this challenge was overruled by the European Court of Justice which said the ECB did not have the legal power to do so. As the UK’s  HM Treasury’s claimed at the time, such an edict would have discriminated against non-Eurozone countries which are part of the EU.

Fast forward to this latest clash, post-Brexit. This time City observers I’ve spoken to claim it is the EU’s politicians rather than the regulators that want clearing taken onshore, a move prompted more by gesture politics than harsh economic reality. Insiders say that behind the scenes, the eurozone’s technocrats, the bankers, regulators and officials working at the ECB and within ESMA, are more alive to the dangers of forcing banks to move their clearing on shore.

But they are having to show they take seriously the sabre-rattling of the continent’s politicians. “We rather hope that those who understand financial markets and the critical importance of the global infrastructure that LCH has in place, the technocrats will be able to persuade the politicians to find a solution,” says another senior figure in the market.

Indeed, there are some hints of a change in mood. In a recent speech to a conference in Frankfurt, Fabio Panetta, member of the ECB board and former director general of the Bank of Italy, seemed to suggest a broader approach. Panetta said: “Requiring more critical services to be provided by EU CCPs would also make our domestic clearing landscape more systemically important, and would increase cross-border risks within the EU. In such a scenario, the current framework for supervising EU CCPs – which still largely relies on national authorities and gives ESMA and the Eurosystem a limited role – would not be fit for purpose.”

Which is why Jake Pugh, a former Brexit party MEP and another expert on financial markets infrastructure, says the EU has lost its marbles over clearing: “The EU’s latest attempt to bring back euro clearingfrom the City is like the UK telling Germany to bring all its car manufacturing to Britain. “

“It just does not make economic sense: what everyone is missing is that the EU won’t get what it is hoping for by trying to force firms to undertake their clearing. Costs will go up for everyone concerned: corporates, asset managers and pension funds and therefore customers.”

It is also likely that any haircuts applied to Eurozone bonds for margin would also apply to the capital of EU banks operating in London. Pugh explains: ” International investors would naturally market to market against the lower value and there could be a run on the Euro and the creation of an onshore/offshore Euro. The aspiration for the Euro to be a reserve currency would be over.” 

Indeed, one of the arguments being put forward by LCH and the Bank of England to their European counterparts is that if they hope for the Euro to be a truly global currency, then clearing in London is the most appropriate place to be rather than broken up across the continent’s CPPs.

Pugh adds: “The real target for the EU commission is interest rate swaps. They claim it’s systemic but like much of what comes out of Brussels, it’s rather economic with the actualite. You can make an argument for the systemic importance of repo and credit. Repo is the primary monetary policy tool of the ECB. But whatever EU27 clients view on the Euro interest rate curve has zero systemic significance. This is not about supervision and surveillance. The EU and ECB fear that LCH and the Bank of England would haircut European government bonds as they did in the last euro crisis.”

And it is perhaps this threat that Bank governor Bailey implied when he said there would be a British response. More pertinently, market participants fear that shifting clearing to new clearing houses would lead to a seismic shock to the financial system. Closing down these vast interest-rate derivative trading positions cannot just be done with the flick of a switch, or moved or transferred out of London overnight. 

Interest-rate swaps are ethereal, notional creatures and do not have a physical form like equities or bonds, they are not fungible. If the Bank of England wanted to play dirty, it could of course disallow the transfer of these positions. Experts fear that if you move one currency into a new CCP, you lose all the risk offsets against the other currencies. Also, Pugh says, there is real market concern that European clearing houses do not have the requisite risk knowledge and skill set – both for margin setting and default management which has been built up in London over the decades.

“If the EU did mandate the move, there would be a huge one off costs to EU27 end customers because typically the real money buy-side (insurance companies, asset managers, pension funds) tend to be one way so they would get slaughtered on the trade,” he says.

He warns that by trying to grab interest rate swap clearing out of London, the end result may well be to push customers into the hands of the CME, the US exchange, because it has deeper liquidity and a greater suite of futures contracts. 

Daniel Hodson, former chief executive of the Liffe futures market and chairman of the CityUnited Project lobbying group, says this: “Trying to move clearing – like any liquidity- is like trying to grab soap in the shower. Ultimately, it’s in the gift of the powerful firms using the clearing houses and they aren’t going to be happy.  It will put them working inside the EU wall financial service garden.”

Hodson adds: “If the EU tries to isolate Euro denominated clearing then the margins put up by clearing institutions will rise, and that will need more capital, which is short supply, and resources to manage.”

And, he says, in order to manage the additional risk posed by bringing new business in the EU based clearing houses will have to find more capital, which again is in short supply.

How seriously should one take the EU’s claims that post-Brexit, LCH would want to ‘diverge’ from the current regulations, in other words, lower their regulations?

Nonsense, say market experts I’ve spoken to, the LCH is a global player, operates by global rules and the last thing it would want to do is drop its standards. The Bank of England, which supervises LCH, already follows the EC’s European Market Infrastructure Regulation to the last dot, and even gold-plates some of the rules.

As another source close to the clearing discussions adds: “It would not make sense for LCH to diverge from any other CCP because the entire business is built on the highest standards and the highest degree of trust. If anything, LCH will alway push for the highest standards of international regulation.”

So what is the end-game? And how far will the EU test the resolve of the Bank of England to go for a British response? As Bailey says, if it comes to it he has an armoury of tools. For example, if the EU were to force business out of London, the UK could retaliate by forcing EU customers out of other clearing houses such as LME Clear and ICE Clear. Many of the products and services cleared in these CPPS are not available in the EU which would mean there are huge chunks of EU 27 risk exposure which would be unhedged.  

Can there be a mutually beneficial solution which finds favour with both sides, one which gives the EU’s politicians some get-out clause to climb down from their high horse? Bailey and the Bank of England are understood to be hopeful that the ECB, headed by Christine Lagarde, will eventually see sense. With any luck, the technocrats on both sides can help persuade the European Commission and the EU’s politicians to stop the flag-waving and understand they will only hurt their own economies in the long-term if they pursue such protectionist measures. Maybe they can point to the mess the EU made of trying to run vaccine procurement to make the case.