The Strategist

Brussels vs. London: What will happen to the Euro clearing market

06/16/2017 - 15:27

Negotiations on Brexit are yet to be started, and Brussels is already preparing to live in a new reality, in which the City of London will be outside the EU.

On Tuesday, the European Commission described its plans for the London Eurobond clearing market, which causes envy on the continent. Brussels wants to give EU regulators the authority to check foreign clearing houses. Those of them whose activities will be regarded as representing a "systemic risk" for Europe's financial stability will be exposed to a number of requirements, fulfillment of which will become a condition for access to the EU market. In some cases, they may be instructed to transfer business to the continent.

What is Euro clearing?

The closed world of clearing became the basis of global stability of the financial market after the crisis of 2008. A clearing house, such as the London Clearing House or Eurex Deutsche Boerse, acts as an intermediary between the two parties in a transaction and monitors fulfillment of its terms by the buyer and seller. Now London is the undisputed leader in this market, occupying about 75% on it and providing thousands of jobs in the financial industry.

Turnover of contracts for euro-denominated derivatives in London Clearing House sometimes exceeds 900 billion euros per day. Paris - the second largest player in this market - accounts for only 11% of transactions.

Why did London become the market leader? The financial authorities of the city managed to achieve its dominance in the clearing market, including due to the wide dissemination of British law and the English language. This did not stop the European Union's attempts to expand the market share of competing financial centers, such as Frankfurt am Main and Paris, which also would like to engage in this business and keep the jobs associated with it. Back in 2011, the European Central Bank was trying to insist that all trades with instruments denominated in euros should be conducted in the euro area. However, the European Court of Justice pointed out that the ECB does not have the legal force to make such decisions. The UK, which then applied to the court, argued that the transfer of trade would lead to discrimination against EU member states that are not members of the euro area. Now, as the country leaves the block, this argument will cease to function.

What's bothering Brussels?

The problem is that the current rules practically do not allow the EU to influence regulation of the UK's clearing houses after the country leaves the single market. This causes acute concern, since actions of the British clearing center, including those that are erroneous, can have serious consequences for the EU. For example, a common complaint of European regulators is that LCH aggravated the crisis of the sovereign debt of the eurozone in 2011 by increasing margin requirements - the amount that market participants place as collateral for the transaction - for the debts of Spain and Ireland. And now the EU seeks to fill the lack of control.

What is the EU planning to do?

The EU proposes to provide the European Securities and Markets Agency (ESMA), based in Paris, with the authority to assess the systemic risks created by foreign clearing houses. The agency will study their size, structure and volume of business in EU currencies. The organization’s assessments may lead to introduction of new requirements for clearing houses. What are the new rules of work? Nothing will change for those clearing houses which actions do not imply a potential systemic risk. Those, however, who will be recognized as system-forming players will have to comply with special conditions, including the requirements of the industry standard document known as the Rules for Regulation of the Infrastructure of the European Financial Market, as well as the norms of the central banks of the EU countries, for example, in collateral management matters. Failure to comply with these rules will mean that the clearing house will not be "recognized" by ESMA. This will lead to a sharp increase in the cost of working with the Chamber for European banks. In addition, ESMA and central banks may decide that the clearing house has a "particularly important systemic value" for the financial system. In such cases, Brussels may require to transfer the clearing house to the territory of the EU for the sake of "recognition" of ESMA. The risk of such a development is especially great for LCH, because of the size of the market share it occupies.

How does this relate to the official negotiations for Brexit? Legally there is no connection. The European Commission proposes to amend the EU legislation - and this issue is outside the negotiations for Brexit. However, this shows that Brussels is already beginning to prepare for a life without the UK and that it does not want to rely on the fact that during the negotiations the questions on access of the UK to the market of financial services of the EU will be resolved. 

Is the EU trying to punish the UK for Brexit? Critics say the requirement to conduct euro-denominated transactions in the euro area will lead to creation of a fragmented and less competitive market and an increase in the costs of European customers. According to the London Stock Exchange, a small local trading pool will cause a decline in the effectiveness of transactions. In addition, participants in the decreased pool will find it more difficult to absorb any losses, and, therefore, the risks to the market will increase.

Head of the LSE Xavier Rolet believes that transfer of clearing can cost investors 100 billion euros (83 billion pounds) for five years. The defeat of London may not turn into a victory for the EU. Some volume of clearing operations in euros is being conducted in the US, and many believe that the companies will transfer the business to New York in order to minimize losses.

What consequences will the City of London face?

The announcement made on Tuesday does not directly affect London’s interests. It gives a start to the beginning of a long process involving the European Parliament and the Council, an organization representing national governments in the EU. They can change plans. It is unlikely that market participants will move most of their business to the continent until they receive official instructions. It is extremely beneficial for banks and other market participants to have a small number of large capital pools, and LCH is the largest site for such concentration, with a significant margin. According to a study conducted by EY for the London Stock Exchange last fall, London could lose 83,000 jobs in the industry in the worst scenario for the next seven years. Last year, Rolet warned that Brexit would endanger at least 100,000 jobs in the UK financial sector. Nevertheless, according to the LSE, the clearing transfer will have a small impact on its business, since LCH has a clearing house in Paris that fully complies with EU rules.