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This article is part of the special report Brexit and the City.
This time it’s the European Union that wants to take back control.
Brussels wants to use Brexit to wrest the lucrative business of euro clearing from the City of London.
The move is more than about trying to shift a handsome piece of the financial industry across the Channel. It’s about making sure governments and central bankers have the power to step in and calm the eurozone in times of crisis.
“The fact that a large proportion of euro-denominated contracts are cleared outside the European Union is a point of vulnerability,” is how European Commissioner for Financial Services Mairead McGuinness put it in January.
The trouble for Brussels is not so much that London is opposed to the effort — though it very much is. It’s that moving a sizeable portion of the euro clearing market across the Channel will be difficult without risking the very financial destabilization policymakers are trying to avoid.
“The general size of this exercise might dislocate the markets,” said Ulrich Karl, head of clearing services at the International Swaps and Derivatives Association (ISDA), referring to a widespread migration of portfolios.
Brexit turf wars
The EU’s latest battle with Britain concerns interest-rate swaps — a financial transaction used by fund managers, insurers, pension funds and banks to protect themselves against unexpected changes in the cost of borrowing.
These swaps are “cleared” — that is, monitored and managed — through clearinghouses like LCH in London, by far the major player in the industry. The clearinghouse becomes the buyer to the seller, and vice versa, to guarantee a trade.
These contracts can be denominated in dollars, euros, yen or any other currency and at the moment, 90 percent of those using euros are handled by LCH.
Within the EU, there’s only one clearinghouse that can manage interest-rate swaps: Eurex in Frankfurt.
Getting some or all of euro clearing to shift from London would be a major coup for the EU in the Brexit turf war over financial services. But unlike EU share-trading, much of which jumped to Amsterdam at the start of the year, or even derivatives-trading, the Commission can’t just flip a switch and demand that the clearing business moves over.
The sheer volume alone would make that difficult. LCH manages some €46 trillion of notional outstanding euro-denominated interest-rate swaps — equivalent to more than triple the size of the EU’s economy.
The risks inherent in disrupting a market of that size is why the European Commission has allowed London clearinghouses to keep serving European clients until mid-2022.
But those same risks are also why the EU does not want to leave the market rolling along outside its borders —and why the European Commission has been stepping up pressure on banks and clearinghouses to move their business into the EU.
“The message to the industry is clear,” McGuinness said in January. “Financial entities in the EU are expected to reduce their exposure to U.K. [clearinghouses] and [clearinghouses] within the EU must build up capacity.”
It’s not the first time the EU has tried to onshore euro clearing — and the last time didn’t go well.
In 2011, during the eurozone debt crisis, the European Central Bank warned that a financial, legal or operational problem at a clearinghouse could have knock-on impacts for the euro.
Britain was then still a member of the EU, but for the ECB that wasn’t enough. Angered by a request from LCH for more collateral on Italian government bonds, the Frankfurt regulator wanted euro clearing to move not only into the bloc but into the eurozone itself.
The U.K. successfully sued to fend off the move, and in 2015 the European Court of Justice ruled the ECB didn’t have powers to regulate securities clearing. (Commentators at the time predicted the court’s decision made Brexit less likely.)
The ECB’s concerns have since been mitigated. The euro repo and government-bonds business that fueled its worries has relocated to LCH’s Paris unit. And the European Securities and Markets Authority has been given the power to request information and even inspect the premises of clearinghouses that are critically important to the EU’s financial system — including London’s LCH, ICE Clear Europe and, to a lesser extent, LME Clear.
Most industry insiders say they believe Brussels will find it difficult to prise the international market away from London, and so far EU pension funds and insurers have been reluctant to move their positions into the EU.
The Commission is trying to figure out how to unlock a move by pressing banks on which derivatives would be “easiest” to shift to the bloc — and it has seen a little bit of progress.
Eurex in Frankfurt has been building up capacity and trying to entice banks to move over, resulting in an increase of euro interest-rate swap volumes at the clearinghouse — though not yet enough to make much of a dent in LCH’s business. Germany’s DekaBank, for instance, switched its business from LCH to Eurex in 2019. According to data from Clarus Financial Technology, Eurex’s market share in euro clearing by trading volume hasn’t shifted much over the last year, standing at 3.7 percent across interest-rate swaps, overnight indexed swaps and basis swaps in February.
Analysts say the Commission adoption of a light touch — rather than the ECB’s 2011 show of force — might be a smart approach, given the sensitivities around the industry.
“[The Commission is saying] we are not forcing you … but if you don’t do it, you may not get equivalence,” an industry expert said, asking not to be named due to those sensitivities.
Investment banks are ready to move clients’ portfolios across to Eurex — for a fee, of course, to cover the risks. Japan could also serve as a model, having onshored some of the yen-denominated swap market.
The Commission’s efforts have reportedly infuriated Bank of England Governor Andrew Bailey, who has described them as a “serious escalation” of “dubious legality.”
His comments reference the fact that only 25 percent of the euro clearing market at LCH actually involves EU firms. The rest is made up of international participants — like Japanese banks and U.S. fund managers — and the EU cannot exert any concerted pressure on them without starting a global bun fight.
Another problem involves the nature of interest-rate swaps, which often involve multiple parties, with the clearinghouse working as a middleman and clients unaware of who might be on the other end of their transactions.
That means rather than simply moving contracts regarding EU firms over in bulk, each derivative position at LCH may have to be unwound and then recreated at Eurex — a move that comes with potentially high costs and risk.
The danger of something going wrong would only be greater if the EU engineered a cliff-edge transition — if for instance the Paris-based European Securities and Markets Authority, which is reviewing the industry in light of Brexit, were to recommend that Brussels no longer recognize London-based clearinghouses.
Depending on the nature of the transactions, large numbers of players looking to move their business at once could leave them struggling to find takers for the other side of the contract at Eurex.
Much will depend on how much of the business the Commission is able to entice over the Channel to begin with.
Clearing markets need large volumes of business to be able to easily match up different positions and achieve benefits of scale.
That makes it hard to unstick business from a dominant clearinghouse like LCH. But, on the flip side, if the EU is able to grab some market share and build a pool of liquidity, that would have the potential to create a tipping point, facilitating the flow of business in the EU.
“The plumbing is in place, but someone needs to turn the tap on,” one senior London banker said, speaking on condition of anonymity.
This article is part of POLITICO’s premium policy service: Pro Financial Services. From the eurozone, banking union, CMU, and more, our specialized journalists keep you on top of the topics driving the Financial Services policy agenda. Email [email protected] for a complimentary trial.