At a time when the United Kingdom (UK) is on the verge of overriding on certain provisions of the European Union (EU) withdrawal agreement, when any prospect of an agreement on the future of the EU-UK relationship seems unlikely, and when the European Commission (EC) is soon to decide on the equivalence regime that the British financial sector could obtain, let’s have a look to a unknown and overlooked but no less strategic issue in the Brexit negotiations: the British clearing houses.
What is a Central Counterparty Clearing House (CCP)?
A central counterparty is a financial market infrastructure that interposes itself between the parties to a transaction and substitutes for the seller and the buyer in order to secure financial transactions. A clearing house calculates the net balance from a set of unit transactions. Today, the majority of clearing houses act as central counter-parties, leading to the indifferent designation of a financial infrastructure offering such services.
What is a derivative?
A derivative is a financial instrument between the seller and the buyer who agree on the price of an asset. The particularity of such a financial instrument is that the value of a derivative is derived from an underlying asset or group of assets. Such products make it possible to protect oneself against financial risks, price fluctuations, exchange rate risks etc. and may also be used to speculate on price evolution.
Over-The-Counter (OTC) derivatives are subject to a clearing obligation according to international principles (Principles for Financial Market Infrastructures (PFMI)) and EU law. The establishment and strengthening of such an obligation can be traced to the 2008 financial crisis, following which, in 2009, the G20 summit in Pittsburgh adopted a road map that mandated centralized clearing of financial OTC derivatives instruments. In the EU, the European Market Infrastructure Regulation (EMIR) adopted in 2012 introduced this clearing obligation via clearing houses for the most standardised OTC derivatives.
What is at stake?
Clearing houses are an important issue in financial markets because of their systemic nature, which may become vectors for the propagation of financial risks they are supposed to concentrate. Such importance was first demonstrated during the Eurozone crisis in 2012 when they contributed to liquidity pressure because increased margin requirements or haircuts on collateral have been imposed on Spain, Ireland or Greece a few days after these countries asked for a bailout.
Why does Brexit bring this issue up to date?
London is responsible for 60% of all EU capital markets-related activity. But when it comes to OTC Interest-Rate Swap (IRS), 95% of the euro-denominated IRS are currently conducted in London, against 13% cleared in Paris and 2% in Frankfurt. Almost half of the UK trade in OTC interest-rate derivatives is denominated in euros (48.6%) compared to 4.7% in pounds sterling. Globally, an estimated 930 billion euros worth of euro-based trades are cleared each day through UK CCPs. But Brexit changes the situation, with the UK becoming a third-country, the main issue is that the systemic risk borne by the UK clearing houses, and related decision-making process in the event of a crisis, will shift from within to outside the EU.
While the UK was not in the Eurozone, it benefited from the access to the single market through the European passporting of financial activities, leaving international banks to use London as a base from which to provide financial services across the EU. However, one has to take into account that the dominance of the City of London for euro clearing activities was politically contingent upon the UK’s membership of the EU. It is not its absence from the euro area, but its withdrawal from the Union, and the emergence of new regulatory barriers that makes euro clearing activities more vulnerable to continental competition.
The issue of UK CCPs location
Even before the Brexit referendum in June 2016, UK CCPs were an issue between the UK and the European Central Bank (ECB). The latter institution, in July 2011, published a Eurosystem oversight policy framework arguing that large scale offshore CCPs handling euro-denominated clearing should be located in the euro area with full control by the ECB. However, in March 2015, the European Court of Justice (ECJ) annulled the ECB’s policy framework.
After the result of the referendum, French and German politicians, together with ECB officials revived the clearing houses location debate, perceiving Brexit as an opportunity to make London lose its status in the clearing of euro-denominated instruments. In this ’battle of finance’, the EU institutions were expected to restrict the access of UK financial activities to the single market thus leading to promote the relocation of these financial activities to other continental EU financial centers (Paris, Frankfurt, Dublin or Amsterdam).
To reduce offshore risk to the financial stability of the markets and the stability of the euro, a consensus has emerged on the need to control those risks. Two options emerged:
(1) the implementation of a location policy by limiting the volumes cleared abroad or
(2) the setting-up of a strengthened supervisory framework in which the central bank of issue (the ECB) plays a greater role.
The 2017 revision of the EMIR Regulation did not lead to the adoption of such a strict location policy, making any relocation of clearing houses a last resort possibility. However EMIR II defined a new two-tier system for classifying third-country CCPs according to their systemic nature, systemic third-country CCPs being subject to stricter regulatory requirements and a strengthened EU level supervision. This is why Brexit can also be understood as a cultivated spillover, allowing an EU increased supervision to avoid any supervisory as well as, as a consequence, both geographical and economic fragmentation.
Cooperation rather than competition?
If national actors were willing to attract clearing derivatives activities that have become vulnerable to relocation as a consequence of Brexit, continental financial centers remain far less appealing than London since the comparative advantages of each of the European financial centers cannot offset London’s scale effects. It seems that – in the short term – Brexit is unlikely to challenge London as Europe’s leading international financial center while the European institutions seek to avoid any major disruption in cross-border financial flows in order to guarantee European banks’ access to UK CCPs.
Recognizing structural interdependence with UK CCPs
European policymakers remained remarkably united throughout the Brexit negotiations, defending the integrity of the EU as well as the four freedoms, as opposed to any cherry-picking in the talks, while ruling out the prospect of a special deal for finance.
However, some contingency measures had been adopted to protect the financial sector from disruption when the prospect of a no-deal Brexit got closer.
In December 2018, the EC announced it would grant full but temporary and conditional equivalence to UK CCPs to avoid any major disruption (cliff-edge scenario) in the ongoing trading of derivatives.
In July 2020, since the UK did not intend to request an extension of the transition period beyond 31 December 2020, the EC, in a ’readiness’ communication, was considering granting time-limited equivalence in the area of derivatives clearing from that date. According to the Commission, this is indeed the only area where the executive identifies possible risks to the EU’s financial stability.
Equivalence assessment process
Additionally Brexit is associated with the loss of the financial passport and the need for UK CCPs to apply for equivalence from the EC. This is the ’autonomous, unilateral’ process that applies to other non-EU member CCPs and that is not part of the current negotiations. However, the failure to find equivalence would put European financial firms at risk facing the higher capital charges for transactions cleared in the UK it would imply. For the moment, the EC has sent questionnaires to the UK, covering 28 areas where equivalence assessments are possible. So far, the UK has only answered 4 of these questionnaires.