Another week, another round of baffling Brexit political force. But if you want a different perspective on these ongoing dramas, ponder a topic that almost no British politician ever bothers to discuss: the state of London’s gigantic derivatives market after leaving the EU. For while this topic is arcane, it matters deeply – not just because derivatives have financial stability implications, but also because the issue is sparking some extraordinary behind-the-scenes battles, now with transatlantic consequences. The issue at stake revolves around the clearing of derivatives trades. In recent years, the London clearing House (LCH) has dominated the swaps and futures sector, regularly clearing more than 3 trillion USD of trades each day, of which a quarter are euro – denominated and almost half in dollars.
Continental European politicians have always hated the fact that so much euro business sat in London. But they tolerated this because the UK was in the EU. And while American regulators were also uneasy about so much of the dollar market sitting outside their shores, they accepted it because the UK authorities gave the Commodity Futures Trading Commission (CFTC) sufficient oversight of the LCH dollar business. No longer: European politicians have declared that if LCH wants to clear euros when – or if – Brexit occurs, that business must either move to continental Europe, or be regulated by the European Securities and Markets Authority (ESMA), the Paris-based entity.
In one sense, that is no surprise. And what has come as a relief for the City – and banks – is that ESMA declared recently that it will let London’s clearing houses perform these functions, even after a hard Brexit, as long as they accept ESMA rules. These matters since splitting up the clearing business would be very costly for financial players, as Mark Carney, Bank of England governor, pointed out last month.
However, there is a trillion dollar catch that sits completely outside the British parliament’s control: the US.
The CFTC has told Europe that it will not accept ESMA controlling London’s swaps business insofar as it impinges on dollar markets and US banks. This is partly about national pride – America First. But there is an ideological battle, too. British and US regulators tend to trust market forces, and believe private sector entities should be free to decide how much collateral market participants must post against trades, to cope with default risks. The CFTC almost has two decades’ worth of experience in working with the Bank of England and so far there were rarely any kind of dust-ups.
European regulators, however, do not like the idea of the market alone deciding when to demand more collateral for a transaction in a financial crisis. That is because during the 2011 euro crisis entities such as LCH – and others – imposed such “margin calls” on Spanish and Italian assets – European officials blame this for the dramas – (never mind that this was admirably prudent risk management).
The net result, then, is that European regulators and politicians want to impose more intrusive controls. There need in our opinion to be a clear legal competence in place that, importantly, should cover both EU and third – country CCPs (Central Counter Parties).
However, the Americans vehemently oppose this. Last autumn Mr. Glancarlo, a CFTC commissioner, in an astonishingly tough speech, mentioned that if ESMA meddles too much with the LCH dollar business, the Americans will consider “a range of readily available steps to protect US markets and markets participants. “Privately, some US officials suggest this could include kicking European participants out of the Chicago Mercantile Exchange. Yes, really! This is in our opinion very alarming stuff.
Is there a solution? Not obviously. Right now the protagonists are playing “nice” in public. After the EU recently outlined a broad political framework for handling European clearing, it promised to turn this into tangible rules by 2021. The CFTC and Brussels announced that the CFTC will take part in these preparations. But the real battle in our opinion is most probably just delayed, not resolved. Until the EU unveils its rules in 2021, it is unclear how far LCH will adhere to ESMA’s principles for clearing when -or if- Brexit actually occurs. This uncertainty is not visible when markets are calm. It would be, however, if another crisis hits – and the volume of margin calls increases.
In the meantime, investors should draw two lessons from this saga! First, it shows in our opinion the degree to which Brexit is not just a cross – channel affair – the fiendish logistics in finance affect transatlantic ties too.
Second, it reveals London’s political weakness. The participants notably unable to throw their weight about in this drama are the British regulators. What happens next will be decided by the ideological and territorial fight between Washington and Brussels. So much for “taking back control” in the UK after a possible Brexit.
